Business 6

DR.
BABASAHEB AMBEDKAR
OPEN UNIVERSITY
DBA
DIPLOMA IN BUSSINESS ADMINISTRATION
DBAR-202
Financial Management
FINANCIAL MANAGEMENT
ISBN 978-81-947108-5-1
Editorial Panel
Author
Dr. Himani Sardar
Assistant Professor, GLS University, Ahmedabad
Editor
Dr. H.C. Sardar
Professor, S.D. School of Commerce, Gujarat University, Ahmedabad
Language Editor
Dr. Vasant .K. Joshi
Associate Professor, G.B.Shah Commerce College, Ahmedabad.
Edition : 2020
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ROLE OF SELF INSTRUCTIONAL MATERIAL IN DISTANCE
LEARNING
The need to plan effective instruction is imperative for a successful distance

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tutor, the author (s) and the student are often separated by distance and may
never meet in person. This is an increasingly common scenario in distance
education instruction. As much as possible, teaching by distance should stimu-
late the student’s intellectual involvement and contain all the necessary learning
instructional activities that are capable of guiding the student through the
course objectives. Therefore, the course / self-instructional material are com-
pletely equipped with everything that the syllabus prescribes.
To ensure effective instruction, a number of instructional design ideas are
used and these help students to acquire knowledge, intellectual skills, motor
skills and necessary attitudinal changes. In this respect, students’ assessment
and course evaluation are incorporated in the text.
The nature of instructional activities used in distance education self- instruc-
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terpreted in the acquisition of knowledge, intellectual skills and motor skills.
Students may be encouraged to gain, apply and communicate (orally or in
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by designing instructions that make use of students’ prior knowledge and
experiences in the discourse as the foundation on which newly acquired knowl-
edge is built.
The provision of exercises in the form of assignments, projects and tutorial
feedback is necessary. Instructional activities that teach motor skills need to
be graphically demonstrated and the correct practices provided during tuto-
rials. Instructional activities for inculcating change in attitude and behavior
should create interest and demonstrate need and benefits gained by adopting
the required change. Information on the adoption and procedures for prac-
tice of new attitudes may then be introduced.
Teaching and learning at a distance eliminates interactive communication
cues, such as pauses, intonation and gestures, associated with the face-to-
face method of teaching. This is particularly so with the exclusive use of
print media. Instructional activities built into the instructional repertoire pro-
vide this missing interaction between the student and the teacher. Therefore,
the use of instructional activities to affect better distance teaching is not
optional, but mandatory.
Our team of successful writers and authors has tried to reduce this.
Divide and to bring this Self Instructional Material as the best teaching and
communication tool. Instructional activities are varied in order to assess the
different facets of the domains of learning.
Distance education teaching repertoire involves extensive use of self- instruc-
tional materials, be they print or otherwise. These materials are designed to
achieve certain pre-determined learning outcomes, namely goals and objec-
tives that are contained in an instructional plan. Since the teaching process is
affected over a distance, there is need to ensure that students actively partici-
pate in their learning by performing specific tasks that help them to under-
stand the relevant concepts. Therefore, a set of exercises is built into the
teaching repertoire in order to link what students and tutors do in the frame-
work of the course outline. These could be in the form of students’ assign-
ments, a research project or a science practical exercise. Examples of instruc-
tional activities in distance education are too numerous to list. Instructional
activities, when used in this context, help to motivate students, guide and
measure students’ performance (continuous assessment)
PREFACE
We have put in lots of hard work to make this book as user-friendly as pos-
sible, but we have not sacrificed quality. Experts were involved in preparing
the materials. However, concepts are explained in easy language for you. We
have included many tables and examples for easy understanding.
We sincerely hope this book will help you in every way you expect. All the
best for your studies from our team!
Contents
BLOCK-1: BASICS OF FINANCIAL MANAGEMENT
UNIT-1 INTRODUCTION TO FINANCIAL MANAGEMENT
Finance, Financial Management, Scope of Financial Manage-
ment, Finance and Management Functions, Objectives of Fi-
nancial Management, Role and Functions of Finance Manager,
Changing Role of Finance Manger, Organization of Finance
Function, Liquidity and Profitability, Financial Management and
Accounting, Financial Management and Economics, Financial
Management-Science or Art, Significance of Financial Man-
agement, Strategic Financial Management, Techniques of Fi-
nancial Management
UNIT-2 SOURCES OF LONG -TERM FINANCE
Introduction, Types of Capital, Equity Capital, Preference Capi-
tal, Debenture capital, Term Loan, Convertibles, Warrants,
Leasing, Hire-Purchase, Initial Public offer, Rights Issue, Pri-
vate Placement
UNIT-3 SOURCES OF SHORT TERM FINANCE
Trade Credit, Cash Credit, Bank Overdraft, Letter of Credit,
Factoring, Call/Notice Money, Treasury bills, Commercial Pa-
pers, Certificate of Deposit, Bills of Exchange
UNIT-4 TIME VALUE OF MONEY
Introduction, Future Value; Simple Interest, Compounding In-
terest, Compound value of series of cash flows, Present Value;
Present Value of single amount, Present value of series of cash
flows, Sinking Fund Factor, Loan Amortization
BLOCK-2: COST OF CAPITAL, CAPITAL STRUCTURE AND
LEVERAGES
UNIT-1 COST OF CAPITAL
Concept of Cash Capital, Elements of Cost of Capital, Classi-
fication of Cost of Capital, Opportunity Cost of Capital, Trad-
ing on Equity
UNIT-2 CAPITAL STRUCTURE THEORIES
Introduction to Capital Structure, Factors affecting capital
structure, Features of an optimal capital structure, Capital
Structure Theories, CAP Mand Capital Structure, Adjusted
Present Value
UNIT-3 ANALYSIS OF LEVERAGES
Introduction, Operating Leverage; Meaning, Formulas, When
there can be operating leverage? What is indicated by operat-
ing leverage? Risk associated with operating leverage, Com-
ponents of cost structure which brings higher degree of oper-
ating leverage. Financial Leverage; Formulas, When there can
be financial leverage? What is indicated by financial leverage?
Risk associated with financial leverage, Components of capi-
tal structure which brings higher degree of financial leverage.
Total Leverage; Meaning, Formulas, What is indicated by to-
tal leverage? Risk associated with total leverage
BLOCK-3 : WORKING CAPITAL MANAGEMENT, INVESTMENT
DECISIONS AND DIVIDEND POLICIES
UNIT-1 WORKING CAPITAL MANAGEMENT-I
Introduction, Meaning and Definition of Working Capital,
Types of Working Capital, Factors Affecting Working Capital/
Determinants of Working Capital, Operating Working Capital
Cycle, Working Capital Requirements, Estimating Working
Capital Needs and Financing Current Assets, Capital Struc-
ture Decisions, Leverages
UNIT-2 WORKING CAPITAL MANAGEMENT-II
Inventory Management, Purpose of holding inventories, Types
of Inventories, Inventory Management Techniques, Pricing of
inventories, Receivables Management, Purpose of receivables,
Cost of maintaining receivables, Monitoring Receivable, Cash
Management, Reasons for holding cash, Factors for efficient
cash management
UNIT-3 INVESTMENTS AND FUND
Meaning of Capital Budgeting, Principles of Capital Budget-
ing, Kinds of Capital Budgeting Proposals, Kinds of Capital
Budgeting Decisions, Capital Budgeting Techniques, Estima-
tion of Cash flow for new Projects, Sources of long Term Funds
BLOCK-4: INVESTMENT ANALYSIS AND FINANCIAL PLANNING
UNIT-1 INVESTMENT ANALYSIS
Introduction, Investment and Financing Decisions, Compo-
nents of cash flows, Complex Investment Decisions
UNIT-2 FINANCIAL PLANNING-I
Introduction, Advantages of financial planning, Need for Fi-
nancial Planning, Stepsin Financial planning, Types of Finan-
cial planning, Scope of Financial planning
UNIT-3 FINANCIAL PLANNING-II
Derivatives, Future Contract, Forward Contacts, Options,
Swaps, Difference between Forward Contract and future con-
tract, Financial Planning and Preparation of Financial Plan af-
ter EFR Policy is Determined
UNIT-4 DIVIDEND POLICIES
Introduction, Definition of Dividend, Types of dividend, Forms
of dividend, Dividend and Provision under Companies Act 2013,
Procedure for declaration and payment of Final dividend, De-
terminants of dividend policy, Dividend Policies
Dr. Babasaheb BBAR-202/DBAR-202
Ambedkar
OpenUniversity
BLOCK-1 BASICS OF FINANCIAL MANAGEMENT
UNIT 1
INTRODUCTION TO FINANCIAL MANAGEMENT
UNIT 2
SOURCES OF LONG -TERM FINANCE
UNIT 3
SOURCES OF SHORT TERM FINANCE
UNIT 4
TIME VALUE OF MONEY
BLOCK 1 : BASICS OF FINANCIAL MANAGEMENT
Block Introduction
Finance is considered to be one of the most important aspects of any busi-
ness unit, be it small or large scale unit, every business needs finance and
without finance none of the business can survive and it is because of this
reason the subject of financial management has been introduced in all man-
agement and finance related curriculum.
In this block the whole content has been divided into four units. Unit 1 gives
an introduction to the subject financial management, whereas the unit 2 dis-
cusses about the various sources of long term sources of finance available
infront of an organisation. In unit 1 we will be discussing the main func-
tions covered by the financial management, we shall also be studying the
objectives of financial management. The role of a finance manager is even
very important in the smooth running of the organisation. He has to regularly
monitor the finance condition of an organisation. He will have to know as to
how much funds will be required in the coming days in an organisation. He
has to estimate the funds requirements and arrange the required funds from
different sources. He has to even find the different sources through which
funds can be raised. He has to properly take care of availability of funds
because in absence of funds the whole functioning of the organisation will
come to halt. Apart from this in unit 2nd we will be discussing the various
long term sources of finance available in front of an organisation through
which they can meet their funds requirement. Unit no 3 stands for sources of
short term finance where important sources are discussed. Unit no 4 stands
for time value of money - where future value and present value are dis-
cussed.
So the study of this block is going to be of great help for the future managers
and entrepreneurs in laying the foundation of basics of finance into their
minds and giving them an idea of what exactly is this subject all about.
Block Objective
After learning this block you will be able to understand:
 The main functions of financial management.
 Objectives of the financial management.
 The role of finance manager.
 The scope of Corporate Finance
 The Need for Long-term Finance
 Long Term Finance
 Equity Capital and Preference Capital, Debenture Capital, Term Loans,
Convertible Debentures and Warrants
 Risk return ratio of the different sources
 Short term sources of finance
 Time value of money
 Concept of future value
 Concept of present value
Block Structure
Unit 1 : Introduction to Financial Management
Unit 2 : Sources of Long-Term Finance
Unit 3 : Short term sources of finance
Unit 4 : Time value of money
Unit
INTRODUCTION TO FINANCIAL MANAGEMENT
1
: UNIT STRUCTURE :
1.0 Learning Objectives
1.1 Introduction
1.2 Finance
1.2.1 Meaning and Definition
1.3 Financial Management
1.4 Scope of Financial Management
1.5 Finance and Management Function
1.6 Objectives of Financial Management
1.6.1 Maximization of Firm's Profit/ Profit Maximization
1.6.2 Wealth Maximization
1.7 Role and Functions of Finance Manager
1.8 Changing Role of Finance Manager
1.9 Organization of Finance Function
1.9.1 The Interface of Financial Policy with Corporate Strategic Man-
agement
1.9.2 Interface of Finance Policy and Strategic Management
1.9.3 Interrelationship between Investment Financing and Dividend De-
cisions
1.10 Liquidity and Profitability
1.11 Financial Management and Accounting
1.12 Financial Management and Economics
1.13 Financial Management Science or Art
1.14 Significance of Financial Management
1.15 Strategic Financial Management
1.16 Techniques of Financial Management
1.17 Let Us Sum Up
1.18 Answers for Check Your Progress
1.19 Glossary
1.20 Assignment
1.21 Activities
1.22 Case Study
1.23 Further Readings
1
BASICS OF 1.0 Learning Objectives
FINANCIAL
After learning this unit, you will be able to understand:
MANAGEMENT
 The main functions covered by the financial management.
 The main objectives of the financial management.
 The role of finance manager.
 The linkage of the finance functions with other functional areas.
 The scope of Corporate Finance.
1.1 Introduction
In this unit, the students will be introduced to the basics of Financial Manage-
ment. Objective of financial management is the maximization of shareholder‘s
wealth and necessarily the profits of the business. Three basic functions of
financial management are financial function, investment function, and divi-
dend function. Students will also learn that the role of finance manager has
significantly changed over the years.
1.2 Finance
1.2.1 Meaning and Definition
Finance is an integral part of the overall management rather than the fund
raising activities. It is connected with all financial activities of planning, rais-
ing, allocating and controlling. The scope of financial management is very
wide.
Financial management holds the key to all activities. Finance may be regarded
as a science, for it is a systematized body of knowledge of the phenomenon of
the payment system. Finance is the management of monetary affairs of a com-
pany. It includes determining what has to be paid for and when, raising the
money on the best terms available and diverting the available funds to the
best uses.
– Paul G.Husings
“Finance has to be co-related with production, marketing and accounting
functions of organization in order to reduce or avoid the wastage of funds.”
– Charles Gesten berg.
Check your progress 1
1. Finance has to be co-related with production, marketing and account-
ing functions of organization in order to reduce or avoid the wastage
of funds.
a. Paul G.Husings
b. Charles Gestenberg.
1.3 Financial Management
Financial Management is an integral part of general management. It concerns
managerial decision making. It helps in allocation of future financial require-
ments, allocation of resources and appraisal of financial problems.
2
Definition of Financial Management INTRODUCTION
“Financial management deals with how the corporations obtain the funds OF FINANCIAL
and how it uses them.” – Hoagland MANAGEMENT
“Financial Management is the application of planning and control functions
to the finance function.” – Archer and Ambrosio
“Financial management may be considered to be the management of the fi-
nance function.” – Raymond Chambers
Financial management is the area of business management devoted to a judi-
cious use of capital and a careful selection of sources of capital in order to
enable abusiness firm to move in the direction of reaching its goals.
– J.F. Bradley
1. Financial management deals with how the corporations obtain the funds
and how it uses them.
a. J.F. Bradley
b. Hoagland
1.4 Scope of Financial Management
Scope of Financial Management:
 Forecasting [estimation of the financial requirements]
 Financing [acquisition of capital]
o Allocation of funds
o Investment of funds
o Raising funds
 Co-ordination and control of funds [capital budgeting]
 Profit planning and control
 Decision Making
o Financial decisions
o Investment decisions
o Working capital decisions
o Dividend decisions
1. ...................... is one of the scope of financial management.
a. money
b. finance
c. Forecasting
1.5 Finance and Management Functions
The important management functions are production, marketing and other
functions. There exists inseparable relationship between finance and the other
functions. Almost all business activities, directly or indirectly involve the ac-
quisition and use of funds.
3
BASICS OF The finance function of raising and using money although has a significant
FINANCIAL effect on the other functions, yet it need not necessarily limit or constrain the
MANAGEMENT general running of the business.
The functions of raising funds, investing them in assets and distributing re-
turns earned from assets to shareholders are respectively known as financing
decision, investment decision and dividend decision. A firm attempts to bal-
ance cash inflows and outflows while performing these functions. This is called
liquidity decision.
The finance function includes:
 Long term asset-mix or investment decision.
 Capital mix or financingdecision.
 Profit allocation or dividend decision.
 Short term asset mix or liquidity decision.
Finance functions call for skilful planning, control and execution of a firm‘s
activities.
1. Investment decision
 A firm‘s investment decision involves capital expenditure.
 A capital budgeting decision involves the decision of allocation of capi-
tal or commitment of funds to long term assets that would yield benefits
(cash flows) in the future.
Important aspects of investment decisions:
 The evaluation of the prospective profitability of new investments.
 The measurement of a cut off rate against the prospective return of new
investments could be prepared.
 Investment proposals should be evaluated in terms of both expected re-
turn and risk.
 It also includes replacement decision i.e. decision of recommitting funds
when an asset becomes less productive or non-profitable.
 The opportunity cost of capital is the expected rate of return that an
investor could earn by investing money in financial assets of equivalent
risk.
2. Financing Decision
Financial manager must decide when, where, from whom and how to acquire
funds to meet the firm‘s investment needs. To determine the appropriate pro-
portion of equity and debt is the main aim. The mix of debt and equity is
known as the firm‘s capital structure. The finance manager must strive to
obtain the best financing mix or the optimum capital structure for his firm.
Capital structure is considered optimum when the market value of shares is
maximized.
The change in the shareholder‘s returns caused by the change in profits is
called financial leverage.
4
There must be a proper balance between return and risk. When the INTRODUCTION
shareholder‘s return is maximized with given risk, the market value per share OF FINANCIAL
will be maximized and the firm‘s capital structure will be considered opti- MANAGEMENT
mum.
In practice, a firm considers many other factors such as control, flexibility,
loan covenants, legal aspects etc. in deciding the capital structure.
3. Liquidity Decision
Investments in current assets affect the firm‘s profitability and liquidity. Cur-
rent assets should be managed efficiently for safe guarding the firm against
the risk of liquidity. Lack of liquidity in extreme situations can lead to firm‘s
insolvency.
A conflict exists between profitability and liquidity while managing current
assets. If the firm doesn‘t invest sufficient funds in current assets, it may
become illiquid and risky and would lose profitability, as idle current assets
would not earn anything.
The profitability-liquidity trade off requires that the financial manager should
develop sound techniques for managing current assets. He should estimate
firm‘s needs for current assets and make sure that funds would be made
available when needed.
4. Dividend Decision
The financial manager must decide whether the firm should distribute all profits or
retain them, or distribute a portion and retain the balance. The proportion of profits
distributed as dividends is called the dividend-pay off ratio.
The dividend policy should be determined in terms of its impact on the
shareholder‘s value.
The optimum dividend policy is one that maximizes the market value of the
firm‘s shares.
Dividends are generally paid in cash. But a firm may issue bonus shares.
The function of financial management is to review and control decisions to
commit or recommit funds to new or ongoing uses. Thus, in addition to
raising funds financial management is directly concerned with production,
marketing and other functions within an enterprise whenever decisions are
made about the acquisition or distribution of assets.
1. The mix of debt and equity is known as the firm‘s ..................
a. capital ratio
b. capital structure
2. ............... must decide when, where, from whom and how to acquire
funds to meet the firm‘s investment needs.
a. HR Manager
b. Financial manager
5
BASICS OF 3. ............... assets should be managed efficiently for safe guarding the
FINANCIAL firm against the risk of liquidity.
MANAGEMENT
a. Current
b. fixed
4. The proportion of profits distributed as ................. is called the divi-
dend-pay off ratio.
a. dividends
b. interest
1.6 Objectives of Financial Management
Financial management evaluates how funds are used and procured. The core
of financial policy is to maximize earnings in the long run and optimize them
in the short run. Financial management is an improved resource, mainly capi-
tal funds. The firm‘s investment and financing decisions are unavoidable and
continuous. In order to make them rationally, the firm must have a goal. A
firm‘s financial management may have the following as their objective:
 Maximization of firm’s profit
 Maximization of firm’s wealth
1.6.1 Maximization of Firm’s Profit/Profit Maximization
The maximization of profit is often considered as an implied objective of a
firm. To achieve the a for said objective various types of financial decisions
may be taken. Firms producing goods and services may function in a market
economy. In a market economy prices of goods and services are determined
in competitive markets. Firms in the market economy are expected to pro-
duce goods and services desired by society as efficiently as possible.
Price system is the most important aspect of market economy which indicates
what goods and services society wants.
Higher demand for goods and services leads to higher prices resulting in
higher profit for firms. It attracts other producers due to which competition
in the market increases. An equilibrium price is reached when the supply of
goods in a market matches the demand for those goods. The prices and prof-
its of those goods and services tend to fall which has no demand by the soci-
ety. Prices are determined by the demand and supply conditions as well as the
competitive forces and they guide the allocation of resources for various pro-
ductive activities.
Profit maximization implies that a firm either produces maximum output for
a given amount of input or uses minimum input for producing a given output.
It is assumed that profit maximization causes the efficient allocation of re-
sources under competitive market conditions and profit is considered as the
most appropriate measure of a firm’s performance.
Objections/ criticism to profit maximization
This objective has been criticized. It is argued that profit maximization as-
sumes perfect competition and in the phase of imperfect competition it falls
to achieve its goal.
6
In the new business environment, profit maximization is regarded as unreal- INTRODUCTION
istic, difficult, inappropriate and immoral. There is a possibility of produc- OF FINANCIAL
tion of goods and services that are wasteful and unnecessary from the society‘s MANAGEMENT
point of view. Also, it might lead to inequality of income and wealth. Firms
producing same goods and services differ substantially in terms of technol-
ogy, costs and capital. In such conditions, it is difficult to have a truly com-
petitive price system and thus, it is doubtful if the profit maximizing behaviour
will lead to optimum social welfare.
1.6.2 Wealth Maximization
Wealth maximization objective is as important as profit maximization. The
operating objective of financial management is to maximize wealth or NPV
(Net Present Value) of a firm.
The wealth of owners of a corporation is maximized by raising the price of
the common stock. This is achieved when the management of a firm operates
efficiently and makes optimal decisions in areas of capital investment, financ-
ing, dividend and current assets management.
The market price of a firm‘s stock represents the focal judgment of all mar-
ket participants as to what the value of a particular firm is. It takes into
account present and prospective future earnings per share, the timing and
risk of these earnings, the dividend policy of the firm and many other factors
that bear upon the market price of the stock.
The value/wealth maximization objective of a firm is superior to profit maxi-
mization objective due to the following reasons:
 The value maximization objective of a firm considers all future cash
flows, dividends, EPS, risk of a decision etc. whereas profit maximiza-
tion objective does not consider the effect of EPS, dividend paid or
any other returns to shareholders.
 A firm that wishes to maximize the shareholder‘s wealth may pay regular
dividends, whereas a firm that wishes to maximize profit may refrain
from paying dividend payment to its shareholders.
 Shareholders would prefer an increase in the firm‘s wealth against its
generation of increasing flow of its profits.
 The market price of a share reflects the shareholder‘s expected return
considering the long term prospects of the firm, reflects the differ-
ences in timings of the returns, considers risk and recognizes the im-
portance of distribution orreturns.
The maximization of a firm‘s value as reflected in the market price of a share
is viewed as a proper goal of the firm. The profit maximization can be con-
sidered as a part of wealth maximization.
Other Maximization Objectives
Sales Maximization: The interests of the company are best served by the
maximization of sales revenue, which brings with it the benefits of growth,
market share and status. The size of the firm, prestige, and aspirations are
more closely identified with sales revenue than with profit.
7
BASICS OF Growth Maximization: Managers seek the objectives which give them sat-
FINANCIAL isfaction, such as salary, prestige, status and job security. On the other hand,the
MANAGEMENT owners of the firm (shareholders) are concerned with market values such as
profit, sales and market share. These differing sets of objectives are recon-
ciled by concentrating on the growth of size of the firm, which brings with it
higher salaries and status for managers and larger profits and market share
for the owners of thefirm.
Return on Investment Maximization: The strategic aim of abusiness en-
terprise is to earn a return on capital. If, in any particular case, the return in
the long-run is not satisfactory, then the deficiency should be corrected or the
activity be abandoned for a more favourable one. Measuring the historical
performance of an investment centre calls for a comparison of the profit that
has been earned with capital employed. The rate of return on investment is
determined by dividing net profit or income by the capital employed or in-
vestment made to achieve that profit. Return on investment analysis provides
a strong incentive for optimal utilization of the assets of the company. This
encourages managers to obtain assets that provide satisfactory return on in-
vestment and to dispose off assets that are not providing an acceptable re-
turn. In selecting amongs alternative long-term investment proposals, ROI
provides a suitable measure for assessment of profitability of each proposal.
Social Objectives - The business enterprise is an integral part of the func-
tioning of a country. As such, in return for the privileges and rights granted to
it by the state, the business firm should be made increasingly responsible for
social objectives. The objectives of social accounting include:
 To identify and measure the net social contribution of an individual firm
internally and also those arising from external factors affecting the dif-
ferent segments of the society.
 To determine whether an individual firm‘s strategies and practices are
consistent with widely shared social principles, e.g. discrimination on
the basis of caste, creed or sex will not be permitted.
To make available, relevant information about the firm‘s goals, policies,
programmes, performances, use of and contribution to scarce resources etc.
for example, companies have to disclose their use and earnings of foreign
exchange. Relevant information is that which provides for public account-
ability and also facilitates public decision making regarding capital choices
and social resources allocation.
Financial Objectives of a Firm - The primary financial objectives of a firm
are as follows:
 Return on capital employed or return on investment
 Value addition and profitability
 Growth in earnings per share and price/earnings ratio
 Growth in the market value of the share
 Growth in dividends to shareholders
 Optimum level of leverage
8
 Survival and growth of thefirm INTRODUCTION
Check your progress 5 OF FINANCIAL
MANAGEMENT
1. ............... is one of the long term objective of financial management.
a. Maximization of firm‘s wealth
b. maximisation of firms’s profit
2. ................... evaluates how funds are used and procured.
a. management
b. Financial management
3. The core of financial policy is to maximize earnings inthe ................
run and optimize them in the short run.
a. short
b. long
4. In a market economy prices of goods and services are determined in
............. markets.
a. competitive
b. good
5. ................... maximization implies that a firm either produces maxi-
mum output for a given amount of input or uses minimum input for
producing a given output.
a. wealth
b. Profit
1.7 Role and Functions of Finance Manager
A finance manager is a person who is responsible to carry out the finance
functions. He is one of the members of the top management team and his role
is more intensive and significant in solving the complex funds management
problems. The finance manager is responsible for shaping the fortune of the
enterprise and is involved in the most vital decision of the allocation of capi-
tal. He/she must have abroader and farsighted outlook and must ensure that
the funds of the enterprise are utilized in the most efficient manner.
 He/she plays instrumental role in the overall functioning of anenterprise.
 He is recognized as an integral part of corporate management.
 He is involved in almost all the crucial decision making affairs because
every problem and every decision entails financial implications.
 He groups activities in such a way that areas of responsibility and ac-
countability are clearly defined.
 His focus is on profitability of the firm.
 He is in charge of planning, developing strategies and guiding the man-
agement in all financial decisions.
 Preparation of financial planning, planning for investment economic
appraisal, cost reduction strategies, protection of assets and prepara-
tion of annual report and other important issues are looked after him.
9
BASICS OF  He is also responsible for maintaining good relationship with the banker
FINANCIAL and financia linstitutions.
MANAGEMENT
 He has to fulfil the requirements of periodical payment of interest and
the principal.
 He is also responsible for submitting the regular inventory statements,
cash and fund flow statements to the banker as per the terms and condi-
tions of the loan agreements.
 He has to take key decisions on the allocation and use of money by
various departments.
 He should anticipate financial needs, acquire financial resources and
allocate funds to various departments of the business.
Since the financial manager is an integral part of the top management, he
should shape his decisions and recommendations to contribute to the overall
progress of the business. It is his prime objective to maximize the value of the
firm to its stockholders.
A financial manager often finds himself in a dilemma when he has to choose
between profitability and liquidity. Although both are desirable, sometimes
one has to be sacrificed for the other. His central role requires that he under-
stands the nature of problems so that he may take proper decisions. Apart
from this the main functions of a financial manager are:
 Funds raising
 Funds allocation
 Profit planning
 Understanding capital markets
1. is one of the main functions of finance manager.
a. marketing
b. Funds raising
2. A finance manager is a person who is responsible to carry out the .............
function.
a. finance
b. marketing
3. The finance manager is responsible for shaping the fortune of the enter-
prise and is involved in the most vital decision of the allocation of
.............
a. capital
b. finance
4. A financial manager often finds himself in a dilemma when he has to
choose between profitability and ............
a. returns
b. liquidity
10
1.8 Changing Role of Finance Manager INTRODUCTION
OF FINANCIAL
The information age has given a fresh perspective on the role of finance
MANAGEMENT
management and finance managers. The role of the CFO has emerged and
acts as a catalyst to facilitate changes in an environment where the organiza-
tion succeeds through self managed teams. The CFO must transform himself
from aback office manager to a front end organizer and leader who spends
more time in networking, analyzing the external environment, making strate-
gic decisions and managing and protecting cash flows. In due course of time
the role of the CFO will shift from an operational to a strategic level. Of
course on an operational level, the CFO can‘tbe excused from his backend
duties. The knowledge requirements for the evolution of a CFO extend from
being aware about capital productivity and cost of capital to human resource
initiatives and competitive environment analysis. He has to develop general
management skills for the wider focus encompassing all aspects of business
that depend on or dictate finance.
Fig 1.1 Changing role of finance manager

Financing Decisions
Relationship between Investment, Financing and Dividend decisions
The corporate finance theory has broadly categorized the financial decisions
into investment, financing and dividend decisions. All these financial deci-
sions aim at the maximization of shareholder‘s wealth through maximization
of firm‘s wealth.
Investment decisions
The firm should select only those capital investment proposals whose net
present value is positive and the rate of return on the project exceeds the
marginal cost of capital. In situations of capital rationing, the investment
proposals are selected based on maximization of net present value. The prof-
itability of each individual project will contribute to the overall profitability
of the firm and leads to creation of wealth.
11
BASICS OF Financing decisions
FINANCIAL In general, the financing of capital investment proposals are done in two
MANAGEMENT
forms of finances i.e. equity and debt. The finance decisions should consider
the cost of finance available in different forms and the risks attached to it. The
reduction in cost of capital of each component would lead to reduction in
overall weighted average cost of capital. The principle of trading on equity
should be kept in view while selecting the debt-equity mix or capital structure
decisions. The relative advantages and risk attached to debt financing and
equity financing should also be considered. The lower cost of capital and
minimization of risks in financing will lead to the profitability of the organiza-
tion and create wealth to the owners.
Dividend decisions
The dividend distribution policies and retention of profits will have ultimate
effect on the firm‘s wealth. The company should retain its profits in the form
of reserves for financing its future growth and expansion schemes. The con-
servative dividend payments will adversely affect the firm‘s share prices in
the market. Therefore, an optimal dividend distribution policy will lead to the
maximizationof shareholder’s wealth.
In conclusion, it is viewed that the basic aim of the investment, financing and
dividend decisions is to maximize the firm‘s wealth. If the firm enjoys the
stability and growth, its share prices in the market will improve and will lead
to capital appreciation of shareholder‘s investment and ultimately maximizes
the shareholder‘s wealth.
1. The firm should select only those capital investment proposals whose
net present value is ................
a. equal
b. negative
c. positive
2. The firm should select only those capital investment proposals whose
net present valueis ....................
a. positive
b. negative
3. In general, the financing of capital investment proposals are done in
two forms of finances i.e. ............ and debt
a. loan
b. equity
1.9 Organization of Finance Function
1.9.1 The Interface of Financial Policy with Corporate Strategic Man-
agement
The two important functions of the finance manager are:
 Allocation of funds (investment decision)
12
 Generation of funds (financingdecisions) INTRODUCTION
The theory of finance makes two crucial assumptions to provide guidance to OF FINANCIAL
the finance managers in making these decisions. These are: MANAGEMENT
 The objective of the firm is to maximize the wealth of the shareholders.
 The capital markets are efficient. The corporate finance theory implies
that :
 Owners have the primary interest in the firm.
 The current value of share is the measure of shareholder‘s wealth.
 Introduction To Financial Management
 The firm should accept only those investments which generate positive
net present values.
 The firm‘s capital structure and dividend decisions are irrelevant as
they are solely guided by efficient capital markets and management no
control over them.
However, the theory of finance has undergone fundamental changes overthe
past. It is felt that finance theory is not complete and meaningful without its
linkage with the strategic management. Strategic management establishes an
efficient and effective match between the firm‘s competence and opportuni-
ties with the risks created by the environmental changes.
1.9.2 Interface of Finance Policy and Strategic Management
 Finance policy requires the resource deployment such as materials,
labour etc. Strategic management considers all markets such as mate-
rial, labour and capital as imperfect and changing. Strategies are de-
veloped to manage the business firms in uncertain and imperfect mar-
ket conditions and environment. For forecasting, planning and formu-
lation of financial policies, for generation and allocation of resources,
the finance manager is required to analyze changing market condi-
tions and environment.
 The strategy focuses on how to compete in a particular product mar-
ket segment or industry. For framing strategy it is considered that the
shareholders are not the only interested group in the firm. There are
many other influential constituents such as lenders, employees, cus-
tomers, suppliers etc. The success of a company depends on its ability
to survive in product market environment which is possible only when
the company considered maintaining and improving its product mar-
ket positions. Such considerations have important implications for fram-
ing corporate financial policies.
Hence, the financial policy of a company is closely linked with its
corporate strategy.
The company‘s strategy establishes an efficient and effective match between
its competencies and opportunities and environmental risks. Financial poli-
cies of a company should be developed in the context of its corporate strat-
egies. With the overall framework of the firm‘s strategy there should be a
13
BASICS OF consistency between financial policies - investment,debtand dividend e.g. a
FINANCIAL company can sustain a high growth strategy only when investment projects
MANAGEMENT generate high profits and it follows a policy of low payout and high debt.
1.9.3 Inter relationship between Investment Financing and Dividend De-
cisions
The finance functions are divided into 3 major decisions viz. investment, fi-
nancing and dividend decisions. It is correct to say that these decisions are
interrelated because the under lying objective of these 3 decisions is the same
i.e. maximization of the shareholder‘s wealth. Since investment financing and
dividend decisions are all interrelated one has to consider the joint impact of
these decisions on the market price of the company‘s share and these deci-
sions should also be solved jointly. The decision to invest in a new project
needs finance for investment. The financing decision in turn is influenced by
dividend decision because retained earnings used in internal financing de-
prive shareholder of their dividends. An efficient finance management can
ensure optimal joint decisions. This is possible by evaluating each decision in
relation to its effects on the shareholder‘s wealth.
The impact of taxation on corporate financial management
The tax payments represent a cash outflow from business and therefore these
tax cash outflows are critical part of the financial decision making in a busi-
ness. Taxation affects a firm in numerous ways. The most significant effectsare
asunder:
Tax implication and financial planning: While considering the financial
aspects or arranging the funds for carrying out the business, the tax implica-
tions arising there should also be taken into account. The income of the busi-
ness undertakings is subject to tax at the rates given in finance act.
 The weighted average cost of capital is reduced because interest pay-
ments are allowable for computing taxable income.
 Where a segment of the firm incurs loss but the firm gets overall profits
from other segments
 The income tax act allows depreciation on plant, furniture, and build-
ings owned by the assessed and used by him for carrying on his busi-
ness, occupation and profession.This deprecation is allowed for full
year if an asset was used for the purpose of business or profession for
more than 180 days. Unabsorbed depreciation can be carried forward
indefinitely.
Capital budgeting decisions: The setting up of a new project involves con-
sideration of tax effects. The decision to set up a project under a particular
form of business organization at a particular place, choice of nature of busi-
ness, and the type of activities to be undertaken etc. requires that a number of
tax considerations should be taken into account before arriving at the appro-
priate decision from the angle of sound financial management. The choice of
particular manufacturing activity may be influenced by the special tax con-
cessions available such as-
 Higher depreciation allowance
14
 Amortization of expenditure on know-how, scientific research related INTRODUCTION
to business, preliminary expenses etc. OF FINANCIAL
 Deductions in respect of profit derived from the publication of books etc. MANAGEMENT
 Deductions in respect of profit derived from export business.
1. .............. policy requires the resource deployment such as materials,
labour etc.
a. Insurance
b. Tax
c. Finance
2. The two important functions of the finance manager are .............. and
generation of funds.
a. allocation of funds
b. distribution of funds
3. policy requires the resource deployment such as materials, labour etc.
a. marketing
b. Finance
1.10 liquidity and Profitability
Ezra Solorfion states that liquidity measures a company‘s ability to meet
expected as well as unexpected requirements of cash to expand its assets,
reduce its liabilities and cover up any operating losses.
The balancing of liquidity and profitability is one of the prime objectives of a
finance manager. To maintain concern‘s liquidity, the finance manager is ex-
pected to manage all its current assets and liquid assets in such a way as to
ensure its affectivity with a view to minimize its costs. Under profitability
objective, the finance manager has to utilize the funds in such a manner as to
ensure the highest return. Profitability concept signifies the operational effi-
ciency of an organization by value addition through the utilization of re-
sources i.e., men, materials, money and machines. It refers to a situation in
terms of efficiency in utilization of resources to achieve profit maximization
for the owners. Whereas liquidity means the ability of the organization to
realize value in money, and its ability to pay in cash the obligations that are
due for payment. There is an inverse relationship between Profitability and
liquidity. The higher the liquidity the lower will be the profitability and vice
versa. Sometimes even if the profit from operations is higher, the firm may
face liquidity problems due to the fact that the amount representing the profit
may be in the form of current assets like inventory, debtors-other than in the
form of cash and bank balances. In situations where the firm faces the liquid-
ity problems, will hamper the working of the company which result in lower
profitability of the firm. If more assets of the firm are held in the form of
highly liquid assets it will reduce the profitability of the firm. Lack of liquid-
ity may lead to lower rate of return, loss of business opportunities etc. There-
fore, a firm should maintain a trade off situation where the firm maintains its
optimum liquidity for greater profitability.
15
BASICS OF Check your progress 9
FINANCIAL 1. The balancing of liquidity and profitability is one of the prime objec-
MANAGEMENT tives of a manager.
c. Human Resource
d. Finance
a. Admin
b. General
1.11 Financial Management and Accounting
Similar to production and sales, finance is an independent specialized func-
tion, integrated with other functions. Financial management is a separate
management area. Many organizations have one department for accounting
and finance functions and the finance function is often considered as part of
the functions of the Accountant. But the Financial management is something
more than an art of accounting and book keeping in the sense that, account-
ing function discharges the function of systematic recording of transactions
relating to the firm‘s transactions in books of account and summarizing the
same for presenting in financial statements viz., profit and loss account and
balance sheet, funds flow and cash flow statements. The finance manager
uses the accounting information in analysis and review of the firm‘s business
position to make decisions. Besides the analysis of financial information avail-
able from the books of account and records of the firm, a finance manager
can also use techniques like capital budgeting techniques, statistical and math-
ematical models and computer applications in decision making to maximize
the value of the firm‘s wealth and value of the owners‘ wealth. Considering
these facts, finance function is a distinct and separate function rather than
simply an extension of accounting function. Financial management being an
important function; many firms prefer to centralize the function to keep con-
stant control on the finances of the firm. Any inefficiency in financial manage-
ment will be disastrous for the firm, but for the routine matters, the finance
function could be decentralized with adoption of responsibility accounting
concept. It is advisable to decentralize accounting function to speed-up the
process of information. But since the Recounting information is used in tak-
ing financial decisions, proper control should be exercised on accounting func-
tions in processing of accurate and reliable information to the needs of the
firm. The centralization or decentralization of accounting and finance func-
tions mainly depends on the attitude of the top level management.
1. The uses the accounting information in analysis and review of the
firm‘s business position to make decisions.
a. HR manager
b. director
c. admin anager
d. finance manager
2. The finance manager uses the accounting information in ............. of
the firm‘s business position to make decisions.
a. review
16
b. calculation INTRODUCTION
c. analysis and review OF FINANCIAL
d. none of the above MANAGEMENT
1.12 Financial Management and Economics

It is imperative for the finance manager to be familiar with the micro and
macroeconomic environment aspects of business. Financial management is
based on Economics.
The inverted pyramid of global liquidity
Fig 1.2 Liquidity and Macroeconomics

Microeconomics
This is the study of the economic decisions of individuals and firms. It fo-
cuses on the Optimal operating strategies based on the economic data of
individuals and firms. The concepts of microeconomics helps the finance
manager in taking decisions about price fixation, determination of capacity
and operating levels, break-even analysis, volume-cost-profit analysis, capi-
tal structure decisions, dividend distribution decisions, profitable product
mix decisions, fixation of levels of inventory, setting the optimal cash bal-
ance, pricing of warrants and options, interest rate structure, present value
of cash flows etc.
Macroeconomics
This looks at the economy as a whole, in which a particular business concern
is operating. Macro economics explain policies to control economic activity.
The success of the business firm depends upon the overall performance of
the economy and is affected by the money and capital markets, since the
investible funds are to be procured from the financial markets. A firm operat-
ing within the institutional framework operates on the macroeconomics theo-
ries. The government‘s fiscal and monetary policy will influence the strategic
financial planning of the enterprise. The finance manager must also consider
the other macro economic factors like rate of inflation, real interest rates,
level of economic activity, trade cycles, market competition both from new
entrants and substitutes, international business conditions, foreign exchange
17
BASICS OF rates, bargaining power of buyers, unionization of labor, domestic savings
FINANCIAL rate, depth of financial markets, availability of funds in capital markets, growth
MANAGEMENT rate of economy, government foreign policy, financial intermediation and bank-
ing system etc.
1. ................ is the study of the economic decisions of individuals and
firms.
a. macro economics
b. micro economics
2. .............. economics looks at the economy as a whole, in which a par-
ticular business concern is operating.
a. micro
b. Macro
3. A firm operating within the in situational frame work operate son the
................. economics theories.
a. macro
b. micro
4. The .................. manager must also consider the other macro economic
factors
a. admin
b. marketing
c. HR
d. finance
1.13 Financial Management-Science or Art 1
Financial management is neither a pure science nor specific an art. It involves
various methods and techniques which can be adopted, depending on the
situation of business and the purpose of the decision. As a science it uses
various statistical and mathematical models and computer applications for
solving the financial problems relating to the firm, for example, capital in-
vestment appraisal, capital allocation and rationing, optimizing capital struc-
ture mix, portfolio management etc. In addition to this, a finance manager is
required to apply his analytical skills in decision making. Hence, financial
management is both a science as well as an art.
1. .......... is neither a pure science nor an art.
a. finance
b. accounting
c. Financial management
1.14 Significance of Financial Management
The importance of financial management can be understood from the follow-
ing aspects
Applicability: The principles of finance are applicable wherever there is cash
flow. The concept of cash flow is one of the central elements of financial
analysis, planning control and resource allocation decisions. Cash flow is
18
important because the financial health of the firm depends on its ability to INTRODUCTION
generate sufficient amounts of cash to pay its employees, suppliers, creditors OF FINANCIAL
and owners. Any organisation, whether motivated with earning of profit or MANAGEMENT
not, having cash flow requires to be viewed from the angle of financial disci-
pline. Therefore, financial management is equally applicable to all forms of
business like sole traders, partnerships and companies. It is also applicable to
non-profit organizations like trusts, societies, government organisations, public
sector enterprises etc.
Chances of Failure: A firm having latest technology, sophisticated machin-
ery, highly capable marketing and technical experts, etc. may fail unless its
finances are managed on sound principles of Financial Management. The
strength of business lies in its financial discipline. Therefore, finance function
becomes primary, enabling the other functions like production, marketing,
purchase, personnel etc. to be more effective in achievement of organiza-
tional goals and objectives.
Return on Investment Anybody who invests his money will earn a reason-
able return on his investment. The owners of business try to maximize their
wealth. It depends on the amount of cash flows expected to be generated for
the benefit of owners, the timing of these cash flows and the risk attached to
these cash flows. The greater the time and risk associated with the expected
cash flow, the greater is the rate of return required by the owners. The Finan-
cial management studies the risk-return perception of the owners and the
time value of money.
1. The ................ the time and risk associated with the expected cash
flow, the greater is the rate of return required by the owners.
a. greater
b. lower
2. Anybody who invests his money will earn reasonable on ............... his
investment.
a. dividend
b. return
3. A firm having all the best resources may fail unless itsare managed on
sound principles of Financial Management.
a. finances
b. principles
1.15 Strategic Financial Management
Strategic planning is long range in scope and has its focus on the organiza-
tion as a whole. The concept is based on an objective and comprehensive
assessment of the present situation of the organization and the setting up of
targets to be achieved in the context of an intelligent and knowledgeable
anticipation of changes in the environment. The strategic financial planning
involves financial planning, financial forecasting, provision of finance and
formulation of finance policies which should lead the firm‘s survival and
success. The responsibility of a finance manager is to provide abasis and
information of strategic positioning of the firm in the industry. The firm‘s
19
BASICS OF strategic financial planning should be able to meet the challenges and compe-
FINANCIAL tition and it would lead to firm‘s failure or success. The strategic financial
MANAGEMENT planning should enable the firm to judicious allocation of funds, capitaliza-
tion of relative strengths, mitigation of weaknesses, early identification of
shifts in environment, counter possible actions of competitor, reduction in
financing costs, effective use of funds deployed, timely estimation of funds
requirement, identification of business and financial risk etc.
Fig 1.3 The elements of Strategic financial planning

The strategic financial planning is needed to counter the uncertain and imper-
fect market conditions and highly competitive business environment. While
framing financial strategy, the shareholders should be considered as one of
the constituents of a group of stakeholder‘s viz., shareholders, debenture
holders, banks, financial institutions, government, managers, employees, sup-
pliers, customers etc. The strategic planning should concentrate on multidi-
mensional objectives like profitability, expansion growth, survival, leader-
ship, business success, positioning of the firm, reaching global markets, brand
positioning etc. The financial policy requires the deployment of firm‘s re-
sources for achieving the corporate strategic objectives. The financial policy
should align with the company‘s strategic planning. It allows the firm in over-
coming its weaknesses, enable to maximize the utilization of its competen-
cies and mould the prospective business opportunities and threats to the ad-
vantage of the firm. Therefore, the finance manager should take the invest-
ment and finance decisions in consonant to the corporate strategy. In accor-
dance with the classical management theory, the financial function of an en-
terprise has five main objectives, viz., forecasting, organizing, planning, co-
ordination and control. Each of these objectives has its own range of related
themes.
Forecasting
 Demand and sales volume/revenues
 Cash flows Prices
 Inflation rates
 Labour union behaviour
 Technology changes
20
 Inventory requirements INTRODUCTION
Organizing OF FINANCIAL
 Financial relation MANAGEMENT
 Liaison with financial institutions and clients
 Accounting system
Planning
 Investment planning
 Man power planning
 Developmentprocess
 Marketing strategies
Co-ordination
 Linking finance function with other areas
 Linking with national budget and five year plans
 Linking with labor union policies
 Liaison with media
Control
 Financial charges
 Achievement of desired objectives
 Overall monitoring of the system
 Equilibrium in the capital
1. The finance manager should take the investment and finance decisions
in consonant to the ...............
a. Company policy
b. corporate strategy
2. The requires the deployment of firm‘s resources for achieving the
corporate strategic objectives.
a. financial policy
b. fiscal policy
3. The ................. financial planning is needed to counter the uncertain
and imperfect market conditions and highly competitive business envi-
ronment.
a. complete
b. strategic
1.16 Techniques of Financial Management
The following are some important techniques of Financial Management.
Ratio Analysis - This is an important tool in analysis of financial statements.
Ratios are used as an index or yardstick for evaluating the financial position
and performance of a firm. Ratio is the expression of one figure in terms of
another. It is the expression of the relationship between mutually indepen-
dent figures. Ratio analysis makes use of financial report and data and sum-
marizes the key relationship in order to appraise financial performance. It is
used by the analysts to make quantitative judgment about the financial posi-
21
BASICS OF tion and performance of the firm. There are various ratios which are used by
FINANCIAL different parties for different purposes and can be calculated from the infor-
MANAGEMENT mation given in financial statements. The comparison of past ratios with fu-
ture ratios shows the firm‘s relative strength and weaknesses.
Capital Budgeting Techniques - Investment in long-term assets for increas-
ing the revenue of firm is called as ?capital budgeting‘. It is a decision to
invest funds in long-term activities for future benefits to increase the wealth
of the firm, hence that of the owners. Capital budget in grefersto long-term
planning for proposed capital outlays and their financing. The future growth
of a firm depends on capital expenditure decisions. Capital budgeting involves
large amount of funds, risk and uncertainty and they are of an irreversible
nature. Estimation of cash flow is very important for evaluating the invest-
ment proposals. Capital budgeting results the exchange of current fund for
future benefits which will occur over a series of years to come. The important
techniques used in capital investment appraisal are as follows:
 Payback period method
 Accounting rate of return method
 Net present value method
 Internal rate of return method
 Profitability index method
 Discounted payback period method etc.
Working Capital Management - Techniques like economic order quantity,
ABC analysis, fixation of inventory levels, cash management models etc are
adopted in the efficient working capital management.
Capital Structure - The finance manager has to decide an optimum capital
structure to maximize the wealth of shareholders. In capital structure deci-
sions - analysis of operating and financial leverages, cost of different compo-
nents of capital, EPS - EBIT analysis, ascertainment of EPS and different
financing alternatives, determination of financial breakeven point, indiffer-
ence point analysis and other mathematical models are used.
1. Investment in long-term as sets for increasing the revenue of firm is
called as ?
a. capital ratio
b. capital structure
c. capital budgeting
2. Capital budget in grefersto .................. term planning for proposed capi-
tal outlays and their financing.
a. short
b. long
3. The finance manager has to decide an .............. capital structure to
maximize the wealth of shareholders.
a. minimum
b. optimum
22
1.17 Let Us Sum Up INTRODUCTION
In this unit we discussed the scope of financial management. In this unit unit OF FINANCIAL
we came across several important topics of financial management. MANAGEMENT
In this unit we studied the important concept of wealth and revenue maximi-
zation has been also explained that the wealth maximization and not profit
maximization should be the objective of finance managers. Financial man-
agement is all about how a company obtains the fund and how it utilizes in
today‘s world. Scope of the financial management is wide - from the fore-
casting the funds to the decision making in investment and finance areas. We
even came across the finance manager‘s role and found that it is not re-
stricted to fund mobilization and deployment of funds but he works beyond
that and plays a crucial role in strategy formulation, helping the top manage-
ment in decision making process, helping other departments like accounting,
credit, cash, data processing and tax and informing them about the day to
day activities. We have even studied the techniques of financial management
like Trend Ratios, Cash flow Analysis, Funds Flow Analysis, Ratio Analysis,
Capital Budgeting Techniques Payback period method, Accounting rate of
return method, Net present value method, Internal rate of return method,
Profitability index method, Discounted payback period method, Working
Capital Management, Capital Structure.
So at the end of this unit the readers would have got sufficient introduction
to the subject and gained a lot about the unit.
Answers:(1-b)
Answers:(1-b)
Answers:(1-c)
Answers: (1-b), (2-b), (3-a), (4-a)
Answers: (1-a), (2-b), (3-b), (4-a), (5-b)
Answers: (1-b), (2-a), (3-a), (4-b)
Answers: (1-c), (2-a), (3-b)
Answers: (1-c), (2-a), (3-b), (4-b), (5-a)
Answers: (1-d)
Answers: (1-d), (2-c)
23
BASICS OF Check your progress 11
FINANCIAL Answers: (1-b), (2-b), (3-a) (4-d)
MANAGEMENT
Answers: (1-c)
Answers: (1-a) (2-b) (3-a)
Answers: (1-b), (2-a), (3-b)
Answers: (1-c) (2-b) (3-b)
1.19 Glossary
1. Account Receivable - A balance due from a customer.
2. Accounting Profit - A firm’s net income as reported on its income
statement.
3. Accruals - Continually recurring short-term liabilities especially ac-
crued wages and accrued taxes.
4. Annual Report - A report issued annually by a corporation to its stock-
holders. It contains basic financial statements, as well as management’s
opinion of the past year’s operations and the firm’s future prospects.
1.20 Assignment
Why is financial management more significant for corporate entities than part-
nership firms?
1.21 Activities
Why is integration of finance, investment and dividend functions necessary ?
1.22 Case Study
Visit any company in your area and discuss the functions of a finance man-
ager.
1. Fundamentals of financial management- Dr. Prasanna Chandra.
2. Financial management -Dr. Mahesh Kukris.
3. Financial management -Prof. A. R. Rao.
24
Unit
SOURCES OF LONG-TERM FINANCE
2
: UNIT STRUCTURE :
2.1 Introduction
2.2 Types of Capital
2.2.1 Equity Capital
2.2.2 Preference Capital
2.2.3 Debenture Capital
2.2.4 Term Loan
2.2.5 Convertibles
2.2.6 Warrants
2.2.7 Leasing
2.2.8 Hire Purchase
2.2.9 Initial Public Offer
2.2.10 Rights Issue
Private Placement
2.3 Let Us Sum Up
2.5 Glossary
2.6 Assignment
2.7 Activities
2.8 Case Study
 The Need for Long-term Finance.
 The Important Sources and types of Long Term Finance.
 The Features of Equity Capital and Preference Capital, Debenture Capi-
tal, Term Loans, Convertible Debentures and Warrants.
 Differentiate between all the sources of capital.
 Discuss Risk return ratio of the different sources.
2.1 Introduction
India is geared up to achieve 8% growth rate p.a. Any economy needs fi-
nance to grow as finance is called Life Blood of the businesses. Companies
need finance mainly for two reasons – To meet the long-term requirements
and for meeting the day to day requirements i.e. working capital require-
ments.
The long term decisions of the company include setting up the business,
25
BASICS OF diversification, modernization, expansion and such capital expenditure deci-
FINANCIAL sions. These decisions are for the long term and it takes a long gestation
MANAGEMENT period to see the benefits. Since these decisions involve enormous investment
and are irrevocable in nature, long-term funds are best for them. In this, As-
set-Liability management plays a paramount role. Companies should be pru-
dent in meeting the long-term requirements by the long-term sources of funds
instead of short-term sources of funds. If this is done otherwise, meeting the
long-term requirement by the short- term sources then there would be a mis-
match and this would lead to interest rate risk and interest burden and the
company will have to face liquidity risk eventually.
2.2 Types of Capital
Companies can issue three types of capital – Equity, Preference and Deben-
ture (Loan) capital. These sources distinguish amongst themselves on the
risk, return and ownership pattern.
Fig 2.1 Types of Capital

2.2.1 Equity Capital
Equity shareholders are the owners of the company. After paying a part of
profit to the preference shareholders and other creditors of the company,
they enjoy the residual profits of the company. Their liability is limited to the
amount of share capital they contribute to the company. The benefit of equity
capital to the issuing company is that without any fixed commitment for the
payment of dividends, it offers lifetime capital with limited liability for repay-
ment. Considering the cost of capital, the cost of equity capital is higher than
any other form of capital as–
 The equity dividends are not tax deductible expenses.
 The high cost of issue.
 The equity shareholders enjoy voting rights, so excess of equity capital
in the company‘s capital structure leads to dilution of effective control.
2.2.2 Preference Capital
Preference shares combine the attributes of equity shares and debentures.
Like in the case of equity shareholders, there is no mandatory payment to the
preference shareholders and the preference dividend is not tax deductible
26
(unlike in the case of the debenture holders, wherein interest payment is SOURCES OF
mandatory). The preference shareholders earn a fixed rate of return for their LONG-TERM
dividend payment similar to the debenture holders. In addition to this, the FINANCE
preference shareholders have preference over equity shareholders to the post-
tax earnings in the form of dividends and assets in the event of liquidation.
Preference shareholders generally do not have any voting rights. They may
be entitled to conditional voting rights.
Most preference shares in India carry a cumulative dividend feature, requir-
ing that all past unpaid preference dividends be paid before any ordinary
dividends are paid. In India, both redeemable and perpetual preference shares
can be issued. Perpetual or irredeemable preference shares do not have a
maturity date. Redeemable preference shares have a specified maturity. In
India, redeemable preference shares are not often retired in accordance with
the stipulation since there are no serious penalties for violation of redemp-
tion feature. The call feature permits the company to buy back preference
shares at a predetermined buy back or call price. Call price may be higher
than the par value. Normally, it decreases with the passage of time. The
difference between call price and par value of the preference share is called
call premium.
Preference shares may or may not be convertible. A convertible preference
share permits preference shareholders to convert their preference shares, fully
or partly, into ordinary shares at a specified price during a given period of
time.
Preference shares allow more flexibility and fewer burdens to a company.
The dividend rate is less than that of equity shares and it is fixed. In addition,
the company can redeem it when it does not require the capital. Normally,
when a company reconstructs its capital, it may convert preference capital
into equity capital. Occasionally, equity capital may be converted into prefer-
ence capital. For example, IDBI in 1994 proposed to convert its equity capi-
tal as preference capital.
2.2.3 Debenture Capital
A debenture is a marketable legal contract whereby the company promises to
pay its owner, a specified rate of interest for a defined period of time and to
repay the principal at the specific date of maturity. A debenture is a long term
promissorynoteforraisingloancapital.Thefirmpromisestopayinterestand prin-
cipal as stipulated. The owners of debentures are called debenture holders.
An alternative form of debenture in India is Bond. Bonds are issued primarily
by public sector companies in India.
Debentures are usually secured by a charge on the immovable properties of
the company. If the company issues debentures with a maturity period of
more than eighteen months, then it has to create a Debenture Redemption
Reserve (DRR), which should be at least half of the issue amount before the
redemption commences. The company can also attach call and put options.
With the call option, the company can redeem the debentures at a certain
price before the maturity date and similarly, the put option allows the deben-
ture holder to surrender the debentures at a certain price before the maturity
period.
The interest rate on a debenture is fixed and known. It indicates the percent-
age of the par value of the debenture that will be paid out annually or semi-
27
BASICS OF annually or quarterly in the form of interest. Thus, irrespective of whatever
FINANCIAL might be the market price of the debenture, say, with a 12% interest rate, and
MANAGEMENT a Rs. 1000 par value, it will pay out Rs. 120 annually in the form of interest
until maturity. Paying the interest is legally binding on a company. Debenture
interest is tax deductible for computing the company‘s corporate tax.
Debentures are issued for a specific period of time. In India, a debenture is
generally redeemed after seven to ten years in instalments.
The yield on a debenture is related to its market price; therefore, it could be
different from the coupon rate of interest. Two types of yield could be distin-
guished. The current yield on a debenture is the ratio of the annual interest
payment to the debenture‘s market price. For example, the current yield of a
12% Rs. 1000 debenture currently selling at Rs. 800 is -
Current Yield = Annual Interest / Market Price
= 120 / 800
= 0.15 or 15%
The yield to maturity considers the payments of interest and principal over
the life of the debenture. So, it is the internal rate of return of the debenture.
The yield to maturity is the discount rate that equates the present value of the
interest and principal payments with the current market price of the deben-
tures.
In liquidation, the debenture holders have a claim on assets prior to that of
share holders. However, secure debenture holders have priority over the un-
secured debenture holders
Types of Debentures
Debentures can be classified based on the conversion and security. A few
types of debentures are discussed below:
 Non-Convertible Debentures (NCDs)
 Fully-Convertible Debentures (FCDs)
 Partly-Convertible Debentures (PCDs)
Non-Convertible Debentures (NCDs)
NCDs are pure debentures without a feature of conversion. They is not re-
payable on maturity. The investor is entitled for interest and repayment of
principal.
For example, ICICI offered for public subscription unsecured redeemable
debentures of Rs. 1000 each. These bonds are fully non-convertible and so,
here, the investor is not given the option of converting it into equity. Interest
on the ICICI debentures will be paid half yearly on June 30 and December 31
each year. The company plans to redeem these debentures at par on the ex-
piry of five years from the date of allotment that means the maturity period is
five years. However, ICICI has also allowed its investors the option of re-
questing the company to redeem all or part of the bonds held by them on the
expiry of three years from the date of allotment, provided the debenture hold-
ers give the prescribed notice to the company.
Fully-Convertible Debentures (FCDs)
FCDs are converted into shares as per the terms of the issue with regard to
price and time of conversion. These debentures can be converted into equity
28
shares after a specified period of time at one stroke or in installments. In the SOURCES OF
case of a fully established company with an established reputation and good LONG-TERM
stable market price, FCDs are very attractive to the investors as their deben- FINANCE
tures are getting automatically converted to shares which may at the time of
conversion be quoted much higher in the market compared to what the de-
benture holders paid at the time of FCD issue. Nowadays, companies in
India are issuing FCDs with zero rate of interest.
Partly-Convertible Debentures (PCDs)
These debentures issued by companies in India have two parts: a convertible
part and a non-convertible part. Such debentures are known as partly con-
vertible debentures. The investor has the advantage of both convertible and
non-convertible debentures combined into one debenture. For example, Proc-
tor and Gamble Ltd (P and G) issued 4, 00,960 PCDs of Rs. 200 each to its
existing shareholders in July 1991. Each PCCD has two parts: convertible
portion of Rs. 65 each to be converted into one equity share of Rs.10 each at
a premium of Rs. 55 per share at the end of 18 months from the date of
allotment and non- convertible portion of Rs.135 payable in three equal in-
stallments on the expiry of 6th, 7th and 8th years from the date of allotment.
Advantages of Debentures
 Is a cheaper source of finance because, investors consider debentures
as a less risky investment and therefore require a lower rate of return
and interest payments are tax deductible.
 Since debenture holders do not carry voting rights, debenture issue
does not cause dilution of ownership.
 Debenture holders do not have share in extra ordinary earnings of the
company. So the payments are limited to interest.
 In the periods of high inflation, debenture issue benefits the company.
Its commitment of paying interest and principal which are fixed de-
cline in real terms.
Disadvantages of Debentures
 Debentures carry legal obligation of interest and principal payment,
which, if not paid, can force the company into liquidation.
 In the case of companies which have fluctuating sales and earnings,
debentures prove to be disadvantageous due to increased financial le-
verage.
 At the time of maturity, debenture involves substantial cash outflows.
2.2.4 Term Loans
Apart from Debentures or Bonds, Term Loans is another major source of
debt finance. Term loans are sources of long term debt and are obtained from
banks and financial institutes like IDBI, ICICI etc. As term loans are ob-
tained for financing large projects, this method of financing is also called
project financing.
Term Loans have a maturity of more than one year but less than ten years.
Term loans provided by FIs generally have maturity of 6 to 10 years while
the ones provided by banks have maturity of around 3 to 5 years.
Term loans are negotiated by a firm directly with a bank or FI, thereby mak-
ing term loans a private placement unlike debentures that are placed for pub-
29
BASICS OF lic subscription. This gives term loans the advantage of low loan raising cost
FINANCIAL as well as ease of negotiation. Also, as term loans need not be underwritten,
MANAGEMENT they also avoid commission and other related costs.
Security is always guaranteed in case of term loans. Primary Security secures
the term loans specifically by using the assets obtained from term loan funds.
Secondary or Collateral Security is used to secure the term loans generally by
using the company‘s current or future assets. Fixed or Floating charge can be
created against the firm’s assets.
In case of fixed charge, the firm needs to pay stamp duty of around 10.5% of
the loan amount while for floating charge; it needs to pay stamp duty of only
0.5%.
Other than asset security, the FIs impose a number of restrictive covenants on
the borrowing firms. Some of these covenants include ensuring that the firm
maintains its minimum asset base by maintaining minimum capital position in
terms of minimum current ratio. The firm may also be required to reduce its
debt- equity ratio by issuing additional equity and preference capital. The
lender can also restrain the borrowing company from incurring additional
debt or even repaying existing loan. The cash outflows of the firm may also
be restricted by restricting dividends or any other capital expenditure. Term
loans have a provision for appointing nominee director by FIs. The role of
this nominee director is to safeguard the interests of the FIs without causing
any interference.
FIs provide heavy loan assistance to the companies due to which the financial
stake of these institutions is substantial. As a result, these FIs had an option of
converting the part of rupee loan into equity, the terms and conditions of
which are decide by FIs themselves.
The schedule for paying the interest and principal is called the repayment
schedule or loan amortization. Interest charges are tax deductible. In India,
the general rate of interest on term loans is above 14-15 percent. However,
loans at concessional interest rates are also available for projects in backward
areas. In India, amortization is executed by repayment of principal in equal
installments and paying the interest on the outstanding (unpaid) loan. This
result in the decline of interest payments over the years and also, the total
loan payment will not be the same for each period. Repaying the loans in
installments saves the company from paying huge amounts at the end of the
maturity. Such payments are termed as balloon payments.
For example, let‘s say an airline company has taken a term loan of Rs. 5 cores
for a period of 9 years from a FI. The interest rate charged will be 15% p.a.
on the outstanding balance. That means, the principal shall be repaid in nine
equal year-end installments. Now, the payment schedule will include both,
the interest as well as the principal payment. The interest calculation will be
on the outstanding loan amount. As the amount was borrowed at the begin-
ning of the first year, the interest at the end of the year will be
0.15 X 2, 00, 00,000 = 30,00,000
The instalments on the principal will be
2,00,00,000 / 9 = 22, 22,222.22
Thus, at the end of first year, the loan balance will be
2, 00, 00,000 - 22, 22,222.22 = 1, 77, 77,777.78
30
This balance will be used to calculate the interest rate for next year. SOURCES OF
2.2.5 Convertibles LONG-TERM
A debenture that can be changed into a specified number of ordinary shares FINANCE
at the option of the owner is known as a convertible debenture. As a result,
this debenture not only promises the investor a fixed income associated with
it, but also the capital gains associated with the equity share once the owner
has exercised its conversion option. Due to this combination of capital gains
and fixed income, convertibles are also called as a hybrid security.
Whenever a company issues convertibles, it specifies the terms of conversion
like the number of equity shares in return of the convertible debenture, the
price of conversion and also the place and time of conversion option execu-
tion.
The number of equity shares that an investor can receive on exchange of his
convertible debenture is called conversion ratio. Likewise, the price paid for
the equity share at the time of conversion is the conversion price. The con-
version ratio can be found out easily if the par value of the convertible secu-
rity and its conversion price is known–
Conversion Ratio = Par value of convertible debenture / Conversion Price
In India, generally both, the conversion ratio and the conversion price are
specified by the companies. The ways in which the conversion price is set in
developedcapitalmarketslikethatofUSAandinadevelopingmarketlikeIndia is
different. In India, the conversion price is set much below the share‘s market
price prevailing at the time of issue whereas in USA, it is set much above the
share‘s prevailing market price.
The buyers of convertibles are safeguarded against the dilution arising due to
share split or bonus share issue.
The valuation of convertible debentures combines both fixed income securi-
ties as well as ordinary shares. This makes the valuation of convertible de-
bentures more complex than that of non-convertible securities. Thus, the
market value of the convertible debenture depends on market price of a share,
conversion value and also the value of non-convertible or straight debenture
known as investment value.
The conversion value of a convertible debenture is the product of conversion
ratio and the market price of the ordinary share. i.e.
Conversion Value = Conversion Ratio X Share Price
For example, the conversion ratio for the convertible debenture of a com-
pany is 2 and the market price of its share is Rs. 150, then
Conversion value = 2 X 150
= Rs. 300
The non-convertible debenture (NCD) is also known as a straight debenture.
The value of NCD is the value of convertible debenture without the feature
of conversion. This value of the convertible is known as the investment value
or the security value. It is equal to the sum of the present value of future
interest payments and principal redemption at the required rate of return.
31
BASICS OF Need for issuing convertible debentures
FINANCIAL  The main idea of issuing convertible debenture is to make the issue
MANAGEMENT attractive so that it is fully subscribed. Generally, fixed interest con-
vertible debentures are preferred over non-convertible because it en-
titles to earn a definite, fixed income with the chance of making capital
gains. So the convertibility feature becomes attractive.
 When the company issues a convertible debenture, the company is ef-
fectively selling ordinary shares in future. This is done when the com-
pany considers the current market price of its share to be low, but
wants to issue shares at a higher price. It is done by setting the conver-
sion price higher than the ordinary share‘s prevailing market price.
 The company issues convertible debenture as a deferred equity financ-
ing to avoid immediate dilution of the earnings per share. For this, the
company uses fixed income security and does not increase the number
of issued shares until its investment starts paying off.
 The company may issue convertible debentures over equity financing
since it is a cheaper source of finance. The company can use such funds
to finance a large expansion, modernization or diversification project.
By doing so, the convertible debenture holders, who initially provided
cheap funds to the company can now convert their debentures into
ordinary shares and participate in the prosperity of the company.
2.2.6 Warrants
A warrant allows the purchaser to buy a fixed number of ordinary shares at a
particular price during a specified period. Warrants are issued along with
debentures as ?sweeteners‘. Nowadays warrants are issued by big, profitable
companies as a part of a major financing package. Warrants can be used
along with ordinary or preference shares, to improve the marketability of the
issue.
The exercise price of a warrant is the price at which its holder can buy the
issuing firm‘s ordinary shares. The exercise ratio is the number of ordinary
shares that can be bought at the exercise price per warrant. This concept is
like the conversion ratio in case of the convertible securities. If the exercise
ratio is 1:1, that means the holder of warrants is allowed to buy one ordinary
share in exchange for one warrant at the exercise price.
The expiration date is the date when the option to purchase ordinary shares in
exchange for warrants expires. Normally, the life of warrants is between 5
and 10 years. However, some warrants are perpetual-they do not have any
expiration date.
A warrant can either be detachable or non-detachable. When the warrant is
sold separately from the debenture or preference share to which it was origi-
nally attached, it is called a detachable warrant. A non-detachable warrant
cannot be sold separately from the debenture to which it was originally at-
tached.
Warrants entitle to buy ordinary shares. So, the holders of warrants are the
shareholders of the company until they exercise their options. As a result,
they do not enjoy right to vote or receive dividends. They become the
company‘s ordinary shareholders, once they exercise their warrants and pur-
chase ordinary shares.
32
2.2.7 Leasing SOURCES OF
Leasing method of long term source of finance has become very common LONG-TERM
among the manufacturing companies. Leasing facility is usually provided FINANCE
through the mediation of leasing companies who buy the required plant and
machinery from its manufacturer and lease it to the company that needs it for
a specified period on payment of an annual rent. For this purpose a proper
lease agreement is made between the lesser (leasing company) and lessee
(the company hiring the asset). Such agreement usually provides for the pur-
chase of the machinery by the lessee at the end of the lease period at a mutu-
ally agreed and specified price. It may be noted that the ownership remains
with the leasing company during the lease period. Sometimes, a company, to
meet its financial requirements, may sell its own existing fixed asset (machin-
ery or building) to a leasing company at the current market price on the
condition that the leasing company shall lease the asset back to selling com-
pany for a specified period. Such an arrangement is known as ?Sell and Lease
Back‘. The company in such arrangement gets the funds without having to
part with the possession of the asset involved which it continues to use on
payment of annual rent for the lease. It may be noted that in any type of
leasing agreement, the lease rent includes an element of interest besides the
expenses and profits of the leasing company. In fact, the leasing company
must earn a reasonable return on its investment in lease asset. The leasing
business in India started, in seventies when the first leasing company of India
was promoted by Chitambaram Group in 1973 in Chennai. The Twentieth
Century Finance Company and four other finance companies joined the fray
during eighties. Now their number is very large and leasing has emerged as
an important source. It is very helpful for the small and medium sized under-
takings, which have limited financial resources.
2.2.8 Hire Purchase
Hire purchase is a form of instalment credit. Hire purchase is similar to leas-
ing, with the exception that ownership of the goods passes to the hire pur-
chase customer on payment of the final credit instalment, whereas a lessee
never becomes the owner of the goods.
Hire purchase agreements usually involve a finance house.
i) The supplier sells the goods to the finance house.
ii) The supplier delivers the goods to the customer who wills eventually
purchase them.
iii) Sources of Long-Term Finance
The hire purchase arrangement exists between the finance house and the
customer.
The finance house will always insist that the hirer should pay a deposit to-
wards the purchase price. The size of the deposit will depend on the finance
company’s policy and its assessment of the hirer. This is in contrast to a
finance lease, where the lessee might not be required to make any large initial
payment.
An industrial or commercial business can use hire purchase as a source of
finance. With industrial hire purchase, a business customer obtains hire pur-
chase finance from a finance house in order to purchase the fixed asset. Goods
bought by businesses on hire purchase include company vehicles, plant and
machinery, office equipment and farming machinery.
33
BASICS OF 2.2.9 Initial Public Offer
FINANCIAL When a company reaches a certain stage in its growth, it may decide to issue
MANAGEMENT stock, or go public, with an initial public offering (IPO). The goal may be to
raise capital, to provide liquidity for the existing shareholders, or a number of
other reasons.
Any company planning an IPO must follow rules and regulation of SEBI and
stock exchanges.
In most cases, the company works with an investment bank, which under-
writes the offering. That means marketing the shares being offered to the
public at a se t price with the expectation of making a profit.
2.2.10 Rights Issues
The following definition have been provided by the Chartered Institute for
Management Accountants (CIMA): A Rights issue is the raising of new capi-
tal by giving existing shareholders the right to subscribe to new shares and
debentures in proportion to their current holdings. These shares are usually
issued at a discount to the market price. A shareholder not wishing to take up
a rights issue may sell the rights.
The advantages to rights issues are as follows:
 Rights issues are cheaper than offers for sale to the general public.
 This is partly because no prospectus is required but also because the
administration is simp lerand the under writing costs are less. An offer
for sale is a means of selling share to the public at large based on infor-
mation held in a prospectus. Underwriters are financial institutions which
agree (in exchange for a fee) to buy any unsubscribed shares at the
issue price.
 Rights issues are more beneficial to existing shareholders than issues to
the general public. New shares issued at a discount to the market price
to make them more attractive to investors.
 Relative voting rights are unchanged as long as all the investors take up
their rights.
 The finance raised may be used to reduce gearing by paying off long
term debt.
2.2.11 Private Placement
Definition:
The sale of securities to a relatively small number of select investors as a way
of raising capital. Investors involved in private placements are usually large
banks, mutual funds, insurance companies and pension funds. Private place-
ment is the opposite of a public issue, in which securities are made available
for sale on the open market.
Since a private placement is offered to a few, select individuals, the place-
ment does not have to be registered with the Securities and Exchange Com-
mission. In many cases, detailed financial information is not disclosed and a
need for a prospectus is waived. Finally, since the placements are private
rather than public, the average investor is only made aware of the placement
after it has occurred
34
Check your progress 1 SOURCES OF
1. .................. combine the attributes of equity shares and debentures LONG-TERM
a. bonds FINANCE
b. equity shares
c. bonus shares
d. Preference shares
2. A .......... is a marketable legal contract whereby the company promises
to pay its owner, a specified rate of interest for a defined period of
time.
a. shares
b. bond
c. debenture
d. equity
3. ............. are pure debentures without a feature of conversion.
a. NCDs
b. FCDs
4. ................ are converted into shares as per the terms of the issue with
regard to price and time of conversion.
a. NCDs
b. FCDs
5. A .................... that can be changed into a specified number of ordi-
nary shares at the option of the owner is known as a convertible de-
benture.
a. bonds
b. share
c. debenture
2.3 Let Us Sum Up
In this unit we studied the importance of finance in business and about the
various sources exposed to a business through which funds could be ar-
ranged.
We studied in this unit that finance is the life blood of a company. Companies
need finance mainly for two reasons - To meet the long-term requirements
and for meeting the day to day requirements i.e. working capital require-
ments. We even studied about the various sources of finance. We studied that
the long term decisions of the company comprise of setting up the business,
diversification, modernization, expansion and such capital expenditure deci-
sions. These decisions are for the long term and it takes a long development
period to see the benefits. We have seen two projects in this chapter which
shows the different sources of financing for the long-term investments in the
company. There are different sources of long-term financing. They are - Is-
sue of Securities, Term Loans, Internal Accruals, Suppliers credit schemes,
Equipment financing. Equity shareholders are the owners of the company.
After paying the part of profit to the preference shareholders and other credi-
tors of the company, they enjoy the remaining profits of the company. The
preference shareholders earn a fixed rate of return for their dividend pay-
35
BASICS OF ment similar to the debenture holders. In addition to this, the preference share-
FINANCIAL holders have preference over equity shareholders to the post-tax earnings in
MANAGEMENT the form of dividends and assets in the event of liquidation. A debenture is a
long term promissory note for raising loan capital. The firm guarantees to pay
interest and principal as fixed. The owners of debentures are called debenture
holders. There are three types of debentures - Non-Convertible debentures
(NCDs), Fully-Convertible Debentures (FCDs) and Partly-Convertible De-
bentures (PCDs).
So after going through this unit the readers would have got the sufficient
information about financial management and this unit and this would be of
great help for them in understanding the basics concepts of financial manage-
ment.
Answers: (1-d), (2-c), (3-a), (4-b), (5-c)
2.5 Glossary
1. Convertible Currency - A currency that may be readily exchanged for
other currencies.
2. Convertible Security - A security, usually a bond or preferred stock,
that is exchangeable at the option of the holder for the common stock
of the issuing firm.
3. Debenture - A long-term bond that is not secured by a mortgage on
specific property.
2.6 Assignment
State the different sources of long-term finance in India and explain their
features.
2.7 Activities
Differentiate between Equity capital and preference capital.
2.8 Case Study
Study the projects of Jet Airways and Kingfisher airlines and state your ob-
servations about the sources of finance they have used.
1. Financial management-ICFAI.
2. Financial management - I. M. Pandey.
3. Financial management - G. Sadarsan Reddy.
36
Unit
SOURCES OF SHORT TERM FINANCE
3
: UNIT STRUCTURE :
3.1 Introduction
3.2 Sources of Finance
3.2.1 Trade Credit
3.2.2 Cash Credit
3.2.3 Bank Overdraft
3.2.4 Letter of Credit
3.2.5 Factoring
3.2.6 Call / Notice Money
3.2.7 Treasury Bills
3.2.8 Commercial Papers
3.2.9 Certificate of Deposit
3.2.10 Bill of Exchange
3.3 Let us sum up
3.4 Answers for check your progress
3.5 Glossary
3.6 Assignment
3.7 Activities
3.8 Case Study
After learning this unit, you will be to understand:-
 The need of short term of Finance.
 Short term sources of Finance.
 Importance and utility of each source of finance
 Special features of each source of finance.
 Difference among these sources of finance.
3.1 Introduction
From the view point of time
There are two types of sources of finance
(i) Long term sources of finance
(ii) Short term sources of finance
Both sources of finance have their specific role. A long term source of fi-
nance has relation with capital budgeting decision. On the other hand short
term sources of finance have relation with working capital management. Long
37
BASICS OF term sources of finance are used for long term investment, like investment in
FINANCIAL plant, machineries, equipments, land, building etc. The purpose of long term
MANAGEMENT sources of finance and long term investments are different then short term
sources of finance and their investment in short term assets.
Short term sources are those type of sources of finance whose duration of
use is less than one year.
Objectives and features of short term sources of finance are as follows:-
(i) To maintain the liquidity of the enterprise.
(ii) To meet day to day requirement of routine business transactions.
(iii) The maturity period is less than one year
(iv) Different types of sources of finance are available
(v) This indicates short term solvency status of the enterprise.
3.2 Sources of finance
The use of short term sources of finance is not confirmed to the manufactur-
ing and service sectors. But short term sources of finance are used by govern-
ment and banks also. For government short term source of finance is treasury
bills of 91 days, 182 days and 364 days while for banks short term source of
finance is certificate of deposit. For business organization these sources are
creditors of goods and expenses, bills payable, bank overdraft, cash credit,
trade deposits, short term loan, bills discounting, factoring etc. This unit deals
with short term sources of finance of manufacturing and service enterprises.
All these sources are explained in the context of working capital manage-
ment.
Sources of Finance

 
Long Term Short Term

 
Money market Sources of working
instruments capital
 
Treasury Bills Trade Credit
Commercial Papers Cash Credit
Certificate of Deposit Bank Overdraft
Call/Notice Money Letter of Credit
Bills of Exchange
Factoring
Equity Share Capital
Preference Share
Capital
Debentures
Long Term Loans
3.2.1 Trade Credit

This source of finance is very conventional and popular in the business world.
This trade credit is based on norms of industry and business relationship be-
38
tween business enterprise and supplier. It is a facility whereby business enter- SOURCES OF SHORT
prise are allowed by the suppliers of raw materials, services, components and TERM FINANCE
parts etc. to defer the immediate payment to a definite future period, gener-
ally which is less than one year. Any purchase of raw materials and services
obtained without immediate payment to the suppliers is known as trade credit
and is shown balance sheet as creditors under the head of current liabilities.
Another form to obtain materials and service on credit is acceptance of bills.
Here, supplier writes bills (called bills receivable) in the name of receiver
(called bills payables). It is short term liability for the receiver of goods or/
and services. These bills can be discounted by the suppliers with banks and
subsequently payment is paid by receiver to the bank.
These bills are known as Bills of exchange. A bill of exchange is negotiable
instrument. A supplier of goods or / and services is known as writer (the
holder) while receiver is known as drawee of the bill. A bill of exchange is
transferable instrument.
Terms in Trade Credit: There are certain terms are used for trade credit.
These terms are as follows:
(i) Maximum Credit Limit:- Here, supplier determines maximum credit
limit to be given to the customers. This credit limit in terms of rupees
is based on two factors (a) standards of industry and (b) relation with
customer.
(ii) Credit Period: It is the period of time for which trade credit is made
available to the enterprise by the supplier.
(iii) Starting Date: - This is also important term credit period and discount
period are based on this term.
(iv) Cash Discount: - This is one kind of incentive given by the supplier to
customer to make payment before maturity date. It is one type of dis-
count or reduction in debt.
Merits of Trade Credit
The trade credit as a source of financing has the following advantages:-
(i) Trade Credit is readily available according to the prevailing norms.
(ii) Trade Credit is a flexible source of finance, which can be easily ad-
justed to the changing needs for purchases.
(iii) Trade Creditors generally adjust the time of payment keeping in mind
past transactions with the customers.
(iv) Generally trade credit does not involve any flotation costs.
Trade Credit is used to obtained goods on credit for certain period of time.
Thus, it is also one of the sources of finance.
3.2.2 Cash Credit
This facility is provided by the banker to their account holders generally
customer. Under this facility customers are allowed to withdraw money from
their bank account more than their existing balance. The excess withdrawal
amount is predetermined by the banker. This amount varies customer to cus-
tomer. Cash credit facility is known as short term loan. In case of this source
of finance interest is charged on the amount of borrowing and not on bor-
rowing limit. This service is provided by the banker on continues basis.
39
BASICS OF Features of Cash Credit:
FINANCIAL (i) Borrowing Limit: - It is limit based short term loan provided by the
MANAGEMENT bankers. This limit is determined on credit worthiness of the borrower.
A company can withdraw funds up to its established borrowing limit.
(ii) Interest on borrowed amount: - In contrast with other traditional
debt financing methods such as loans, the interest charged is only on
amount borrowed of the cash credit account and not on the total bor-
rowing limit.
(iii) Minimum Commitment Charge: - The short term loan comes with
minimum charges for establishing the loan account regardless of whether
the borrower utilizes the available credit.
(iv) Collateral Security: - Cash credit is often secured using stocks, fixed
assets or property as collateral.
(v) Credit Period: - Cash credit is typically given for a maximum period of
12 months, after which the drawing power is re-evaluated.
3.2.3 Bank Overdraft
It is a short – term borrowings facility made available to the companies in
case of urgent need of funds. The bank will impose limits on the amount they
can lend. When the borrowed funds are no longer required they can quickly
and easily be repaid. The banks issue overdrafts with a right to cash them in at
short notice.
Features:-
 To avail overdraft account facility bank account with respective bank is
mandatory.
 The money extension is granted on the basis of customer’s account
value, repayment history or credit score.
 It is short – term credit provided by the banks that needs to be paid
within the stipulated time period.
 Credit amount or overdraft attracts interest for the time of use which
can be from one day to weeks or months.
3.2.4 Letter of Credit
It is also one time short term credit guarantee issued by the bank for its
customer. A letter of Credit (LC) is a financial document that facilitates inter-
national as well as domestic trade. It is an arrangement by the issuing bank,
on instruction of customer or on its own behalf, undertakes to pay or accept
or negotiate or authorized another bank to do so against stipulated docu-
ments subject to compliance with specified terms and conditions. The docu-
mentary credit is considered as the best payment arrangement since a reputed
bank who pays against the presentation of stipulated documents as mentioned
in the letter of credit.
Features:-
Letter of Credit is very traditional and short term source of finance. There are
certain characteristics of it
(i) Negotiability: - The LC is usually considered as a negotiable instru-
ment can be passed freely.
(ii) Revocability: - The LC can be either revocable or irrevocable.
40
(iii) Transferable: - The beneficiary of LC can be transferred. SOURCES OF SHORT
(iv) Sight and Time based: - A sight form is pad when the LC is presented TERM FINANCE
and the time form is paid after certain duration of time.
Parties to Letter of Credit: - There are three parties.
(i) Applicant (importer / purchaser) requests the bank to issue the Letter
of Credit.
(ii) Issuing bank (importer’s / purchaser’s bank) which issues the Letter of
Credit known as the opening banker of Letter of Credit.
(iii) Beneficiary (exporter / seller) of goods/ services.
Advantage of Letter of Credit
(i) It is useful to expand business internationally with safety
(ii) It is highly customizable
(iii) Seller receives money on fulfilling terms.
(iv) It works as a credit certificate for buyer
(v) Seller is free from any kind of risk on recovery of receivables
(vi) It is very quick to execute the credit worthy parties
(vii) Payment is assured in disputable transactions
3.2.5 Factoring
Under this instrument trade debt of firm is purchased by financial institution
at a discount. Factoring is a regular arrangement between bankers and client.
Here banker is known as factor.
Factoring is a financial service which involves meaning, financing and calcu-
lating receivables. A factor makes the conversion or receivables into cash
possible. Factoring may be defined as a contract between the suppliers of
goods/services.
The core part or component of factoring is purchase of book debts or receiv-
ables. The client (supplier) submit invoice arising from contracts of sale of
goods to the factor. The factor performs at least two of the following ser-
vices
(i) Financing for the seller, by way of advance payments.
(ii) Maintenance of accounts relating to the account receivables.
(iii) Collection of accounts receivables
(iv) Credit protection against default in payment by the buyer.
Factoring Commission:
The commission charge by the factor for providing factoring services is known
as factoring commission. It is generally expressed as percentage of face value
of receivables factored. In India it ranges between 2.5 to 3%.
Top Factoring Companies in India are
(i) IFCI Factors Ltd (ii) SBI Global and (iii) Canbank Factors Ltd, etc.
Parties to Factoring contract
There are three parties in factoring contract
(i) Buyer:- Buyer of goods who has to pay for goods purchased on credit
(ii) Seller: Seller of goods who has to realize for goods sold on credit
41
BASICS OF (iii) Factor: Factor who acts as an agent in realizing credit sales from buyer
FINANCIAL and passes on the realized sum to seller after deducting his commis-
MANAGEMENT sion.
Benefits:
(i) Firm can sale good quantum of goods on credit.
(ii) Flexible cash flow is available to the firm.
(iii) No collateral/security, therefore availability of finance is comparatively
easier.
(iv) More attention can be given to the main business because factoring
reduces the burden of collection.
(v) It is such an arrangement which reduces the incidence of bad debts.
(vi) Expansion of business can be done due to this facility.
3.2.6 Call/Notice Money
This source of finance is deals in overnight funds and deals in funds for 2 – 14
days.
The Narasimhan Committee (1998) recommended that call/notice money
market in India should be made available purely an interbank market. Hence
it is known as ‘Inter Bank Call / Notice Money Market.
There are two important parties Borrowers and lenders.
According to RBI guidelines some parties can play dual role borrowers and
lenders. In case of certain parties their role is confine to lending only.
(i) Borrowers and Lenders
a. All commercial Schedule Banks
b. Co-operative banks
c. Primary dealers listed by RBI
(ii) Only Lenders
a. Selected all Indian Financial Institutions
b. Selected Insurance Companies
c. Selected Mutual Funds
Interest rate is determined by the concern parties. Borrower and lender are
free to determine interest rate.
Why Banks borrow money through call /notice money?
There are two important and valid reasons.
(i) To maintain Cash Reserve Ratio (CRR)
(CRR is the basic tool in the economy which manages inflation and
flow of money in the country. RBI control bank capacity of lending
through CRR)
(ii) The basic function of banks is to accept deposit and to lend loan in
different forms. When accepted deposits are less than lending amount
in this case banks are in needs of short term funds and this needs are
met through this source of finance.
It is useful to the banks when they have surplus funds. Banks can generate
return on it. It is mandatory for banks to maintain statutory liquidity ratio in
42
case of any emergency this source can be used. It provides liquidity in the SOURCES OF SHORT
market and it is very safe shorter time investment opportunity. TERM FINANCE
3.2.7 Treasury Bills
There are three different entities which are using specific source of finance to
meet their short term financial needs. These entities are banks, business en-
terprises and government.
The short term finance needs of government are met with the help of Trea-
sury Bills. This is very crucial instrument for government.
These bills are issued by RBI on the behalf of government. These bills having
duration of 91 days, 182 days and 364 days.
It is totally finance bills. These bills are not created through business transac-
tions. It is very liquid instrument (source of finance). It gives certain return
to investors. No endorsement can be done in these bills like bills of exchange.
It is most safe investment opportunity.
There are two types of Treasury Bills
(a) General or Regular Bills: - These bills are issued by government for
public and other investors to make short term investments.
(b) Adhoc Bills:- There is no tender or auction process for these kind of
bills. Adhoc bills are purchased by RBI from government and issue
currency note.
It is fully secured investment and having very liquidity. Best option for short
term investment. Again it is very important instrument for SLR and CRR.
Another important benefit is, it is very low cost instrument.
3.2.8 Commercial Papers (CPs)
In 1987 Vaghul Committee had recommended introduction of CPs, which
was accepted by RBI in March 1989 and made it effective on 01-01-1998.
The basic objective for introduction of this bill is to enable highly rated cor-
porate borrowers to diversify their sources of short term borrowings and to
provide an additional instrument to investors. Now primary dealers and fi-
nancial institution are permitted to issue CPs. Guidelines for issue of CP are
presently governed by various directives issued by RBI as amended from
time to time.
Commercial Paper is a short tem issuance promissory note issued by a com-
pany in a private sector or public sector at such a discount / interest on face
value as may be determined by the issuing company and negotiable by en-
dorsement and delivery.
 CP is unsecured money market instrument issued in the form of prom-
issory note.
 It can be issued by corporate, primary dealers and all Indian financial
institutions.
 This instrument is issued at discount to face value as may be deter-
mined by the issuer.
 Investment in CP can be made by individuals, banking companies, other
corporate bodies register or incorporated in India.
 It is short term debt for companies.
 Issues of CPs are required to obtain the credit rating certificate for
43
BASICS OF issuance of commercial papers either from CRISIL (Credit Rating In-
FINANCIAL formation Services of India Ltd) or ICRA (The Investment Informa-
MANAGEMENT tion and Credit Rating Agency of India) or CARE (the Credit Analysis
and Research Ltd) or such other agencies as may be specified by RBI
from time to time.
 The maturity for CPs is between 7 days to 1 year from the date of issue.
For CP Master Circular is issued by Reserve Bank of India (RBI), it is
as follows “Master Circular guidelines for issue of Commercial Papers
(July 1, 2015)”.
This source has different advantages, which are as follows:-
 Based on predetermined norms of RBI, so it is trustworthy investment
opportunity
 This instrument eliminates hurdles of liquidity of business enterprise.
 As and when the holder of CP needs to transfer it, can be transferred in
favour of other person.
 It is open investment opportunity. Several parties are allowed to make
investment in this instrument.
 It is such an instrument where companies can avail help from banks or
merchant bankers, because they are considered as expert of this field.
 Credit rating certificate is mandatory for issuer, so due to this provision
investors feel their investment is safe.
3.2.9 Certificate of Deposit (CDs)
Various factors affect expected outcome of financial system. For expected
results in the financial system from time to time different financial instru-
ments are introduced in the money market. All these instruments is having
important role for economy development.
Certificate of deposit is receipt of funds deposited with banks which can be
easily sold in money market. This is an investment in the form deposit where
time period is fixed. This instrument increases mobility of bank deposits. This
scheme was introduced in 1989. Banks accept two types of deposits.
(i) Ordinary Fixed Term: - Such deposits are not negotiable instrument
and therefore cannot be transferred in favour of other person.
(ii) Certificate of Deposit: - It is negotiable instrument and therefore it
can be transferred in favour of other person by endorsement or deliv-
ery. Under this scheme scheduled commercial banks can issue funds
for fix term and it cannot be converted into cash before its maturity but
if investor need cash, he can raise cash by endorsement or delivery.
Certain norms are developed to implement this scheme and certain
modifications are also made on the basis of uncertainties and recom-
mendations. This instrument has special features which are as follows:
 Deposits are sources of raising funds for banks and financial institu-
tions for fixed term.
 Payments are not made before maturity.
 It can be transferred by endorsement or delivery to other person, hence
it is a negotiable instrument.
 Certain norms are developed for issuing deposits.
44
 Such deposits are issued only by scheduled commercial banks. SOURCES OF SHORT
For CD Master Circular is issued by Reserve Bank of India (RBI), it is TERM FINANCE
as follows “Master Circular guidelines for issue of certificate of de-
posits dated July 1, 2013.
This source has different advantages, which are as follows:-
 It is considered to be safe investment instrument because it is issued
by banks under the control of RBI.
 It is open for all types of investors. CD can be issued to individuals,
corporation, companies (including banks and primary dealers), trusts,
association, etc.
 Duration of this investment opportunity is from one day to one year,
from the date of issue.
 It is transferrable instrument can be transferred by endorsement or
delivery and consequently liquidity can be increased.
 There is no lock-in-period.
 It is safe payment of certificate.
There is remarkable role of CDs in the economic development of the nation.
It is very safe financial instrument of money market for all concern investors.
3.2.10 Bills of Exchange
Bill of exchange is defined under section 5 of Negotiable Instrument Act,
1881.
Bill of exchange is a written negotiable instrument, that carries an uncondi-
tional order to pay a specific sum of money to a designated person or the
holder of the instrument as directed in the instrument by the maker.
The bill of exchange is either payable on demand, or after a special fixed
term.
Features:
(i) A bill of exchange an instrument in writing.
(ii) It is drawn and signed by the maker i.e. Drawer of the bill.
(iii) It is drawn on a specific person i.e. drawee, to pay the specified amount.
(iv) It contains unconditional order to a person i.e. drawee.
(v) To make an instrument of value the drawee must accept it.
(vi) The specified amount is payable to the person whose name is men-
tioned in the bill or to his order or to the holder.
(vii) It specifies the date by which amount should be paid.
(viii) Payment of the bill must be in the legal currency of the country.
(ix) It must be properly stamped.
Parties to bill of exchange: - Following are parties to bills of exchange
(i) Drawer: - The person who makes the bill, or who gives the order to
pay a certain sum of money, is the drawer of bill (instrument).
(ii) Drawee: - The person who accepts the bill of exchange or who is
directed to pay a certain amount is called drawee.
(iii) Payee: - The person receiving payment is called the payee, who can be
a designated person or the drawer himself.
45
BASICS OF (iv) Endorser: - Endorser is the person who transfers rights of payment.
FINANCIAL (v) Endorsee:- Endorsee is the person in whose favour the bill of exchange
MANAGEMENT is endorsed by the drawer.
(vi) Bearer:- Bearer is the person in possession of the bearer bill of ex-
change.
Types of Bills of exchange:-
Bills of exchange consist trade transactions involving sale and purchase of
goods. But this mechanism of the bills of exchange can also be of the use in
raising finance.
Type of bill of exchange depends on its objective. There are two types of bills
of exchange from the view point of trade transactions and finance transac-
tions.
(i) Trade Bill: - Trade bill used for trade transaction. Here making and
accepting of bills is based on trade transactions. (Purchase and sale of
goods). This bill of exchange is drawn by the seller of the goods and is
accepted by buyer.
(ii) Accommodation Bill: - Accommodation bill is used to meet financial
needs of drawer and drawee. This bill is for mutual benefit without a
trade transaction. It does not involve a sale or purchase of any goods
or services. This bill carries an agreement between two parties for the
purpose of to meet financial needs of each other.
1. e.g. Mr. Rajan sells goods worth ?10,000 to Mr. Karan on credit. But
Mr. Rajan is in need of finance and he draws bill of ?10,000 on Karan
and it is accepted by Karan.
This is trade bill, because it is emerged from trade transaction between
Rajan and Karan. So here Mr. Rajan is drawer and Mr. Karan is drawee.
2. e.g. Mr. Param and Mr. Praksah are in need of money. Here Param will
draw bill on Prakash and another bill will be drawn by Prakash on Param.
The value of bill is ?10,000 for each. Both can discount these bills with
their banks and get money. On maturity both will pay to the bank. This
is accommodation bill, because it is not emerged from trade transac-
tions. It is emerged from personal financial needs.
Another Classification of bill of exchange
(i) Documentary bill
(ii) Demand bill
(iii) Usance bill
(iv) Inland bill
(v) Clean bill
(vi) Accommodation bill
(vii) Trade bill
(viii) Supply bill
(ix) Fictitious bill
(x) Hundis
46
Check Your Progress SOURCES OF SHORT
1) Debentures are _____________source of finance. TERM FINANCE
(a) Long Term (b) Short Term
2) A Bill of Exchange
(a) Is negotiable instrument (b) is not negotiable instrument
3) Cash credit is provided to the client by the _____________.
(a) Bank (b) Supplier
4) For Bank overdraft interest _____________.
(a) Is not payable (b) is payable
5) LC means ____________
(a) Letter of credit (b) Credit of letter
6) Collection of receivable is function of ____________.
(a) Letter of credit (b) Factoring
7) Treasury Bills are issued _______________.
(a) By central government of RBI.
(b) By RBI for central government
8) Commercial paper is _______________.
(a) Not negotiable instrument
(b) Negotiable instrument
9) Certificate of deposits are issued by ___________.
(a) Banks (b) Comapnies
10) Negotiable instrument Act is of ____________.
(a) 1991 (b) 1981
3.3 Let us sum up
In business organization capital is important element. The need of capital is
categorized in to two categories (i) Long term capital and (ii) Short term
capital. The sources of both the capital are separate from each other. The
short term need of capital (fund) having duration of maximum 12 months. In
fund requirement for the period of less than 12 months is considered as short
term needs.
In Indian financial system financial markets are categorized into two catego-
ries (i) capital market which works for long term sources of finance and (ii)
money market which works for short term sources of finance. The instru-
ments of money market are call / notice money, treasury bills, commercial
papers, certificate of deposit etc.
Another concept working capital management deals with short term finance
which is required for day to day transactions. The sources of working capital
are trade credit, cash credit, bank overdraft, letter of credit, factoring, and
bills of exchange.
All these sources of short finance have their special features, advantages and
limitations. All these instruments and source have relevance for different stake
holders. Stake holders are funds providers and funds borrowers. The specific
purpose is served by specific instrument / source for special stake holders.
47
BASICS OF 3.4 Answers for check your progress
FINANCIAL
Check Your Progress
MANAGEMENT
Answers: - (1-a), (2-a), (3-b), (4-b), (5-a), (6-b), (7-b), (8-b), (9-a), (10 – b)
3.5 Glossary
1. Money Market Instruments: These are those instruments which are
issued by different parties to meet their short term financial needs i.e.
for the period of less than 12 months. This market includes instruments
like call/notice money, treasury bills, commercial papers, certificate of
deposits etc.
2. Sources of working capital: These are those sources of finance which
are required to meet day to day financial needs. The sources of work-
ing capital are trade credit, cash credit, bank overdraft, letter of credit,
factoring, and bills of exchange.
3.6 Assignment
State different types of instrument of Money Market and Sources of Working
capital.
3.7 Activities
(i) Differentiate between Money market instruments and sources of work-
ing capital.
(ii) Undertake study on different types of bill of exchange.
3.8 Case Study
Obtain the guidelines of RBI for any money market instrument and try to
understand the legal provision of them.
1. Financial Management – P. C. Tulsian
Bharat Tulsian
2. Financial Management – Ravi M. Kishore
48
Unit TIME VALUE OF MONEY
4
: UNIT STRUCTURE :
4.1 Introduction
4.2 Future Value
4.2.1 Simple Interest
4.2.2 Compound Interest
4.2.3 Compound Value of series of Cash flows
4.3 Present Value
4.3.1 Present Value of Single amount
4.3.2 Present value of series of cash flow
4.4 Sinking Fund Factor
4.5 Loan Amortization
4.6 Let us sum up
4.7 Answers for check you progress
4.8 Glossary
4.9 Assignment
4.10 Activities
4.11 Case Study
 Concept of Future value and Present value
 Meaning of simple interest and compound interest.
 Compounded Value of series of cash flow
 Present Value of a Single Amount
 Present Value of series of cash flow
 Sinking Fund Factor
 Loan Amortization
4.1 Introduction
In finance the value of money is measured in two terms. (i) Future Value (ii)
Present Value. Future value concept is known interest theory.
Future value is the amount of money that an original investment will grow to
be, over time, at a specific compounded rate of interest .e.g. you have in-
vested R 1000 @4% for 5 years. The amount which gets on maturity (after 5
years) is known as Future Value.
49
BASICS OF This calculation is as follows:
FINANCIAL Investment R 1000
MANAGEMENT
+ Interest @ 4% 40 for the first year
1040
+ Interest @4% 41.60 for the second year
1081.60
+ Interest @4% 43.26 for the third year
1123.86
+ Interest @4% 44.96 for the fourth year
1168.82
+Interest @4% 46.75 for the fifth year
1215.57
On maturity R 1215.57 will be received by the investor and this amount is
known as future value.
Present value is a measure in today’s rupee of the receipt from future cash
flow. In other words, it is comparison of the purchasing power of a rupee
today v/s the buying power of rupee in the future. If investor is estimating to
receive R 1000 after 2 years and interest rate is 4% in this case present value
of R 1000 which is to be received after 2 years @ 4% is R 962 (R 1000 x .962).
.962 is present value of R 1@4% which is to be received after 2 years. This
value is available from present value table. These calculations are based on
certain formulas which are discussed subsequently.
Both concepts of future value and present value are having great importance
in financial management. All relevant aspects pertaining to them are discussed
here.
4.2 Future Value
The concept of future value is very old concept. This concept is conventional
concept in the context of savings to be made to meet future requirements.
Under this concept funds are invested in certain securities to earn interest on
it. In present time it is used by pensioners. Under this title simple interest and
compound interest are calculated. There are certain components which are
required to calculate interest these components are time period –this time
period may be in terms of days, Weeks or months, another component is rate
of interest it is always in the form percentage and last component is principal
amount. This future value can be principal amount and receivable interest.
4.2.1 Simple Interest
Under simple interest, interest in calculated on principal amount at specified
rate. To calculate, total interest, numbers of years are added in it. There are
three components to calculate simple interest amount. These are Principal
Amount, Interest Rate and Number of Years. Different authors used different
variables to define interest formula. For this unit the following formula is
used.
SI = P0 (I) (N)
Where SI = Simple Interest, P0 = Principal Amount on zero day, I = Rate of
Interest, N = Number of years.
50
Illustration:-1 TIME VALUE
Mr. Pankaj has deposited R 50,000 with X bank. This deposit would earn 8% OF MONEY
interest per annum. This deposit is made for the period of 6 years.
(i) Calculate total interest receivable at the end of 6th year.
(ii) Calculate total future value receivable at the end of 6th year.
Answer: -
(i) SI = P0 (I) (N)
= 50,000 x .08 x 6
= R 24,000
(ii) Total Future Value means Principal Amount + Receivable Interest
FVN = P0 + P0 (I) (N)
Where FVN= Future value after N years
FVN = 50,000 + (50,000 x .08 x 6)
= 50,000 + 24,000
= R 74,000
4.2.2 Compound Interest
Under compound interest, interest is calculated on principal as well as inter-
est earned. Here interest of each year is reinvested under simple interest,
interest of each year is not reinvested for the remaining subsequent period
while creation of compound interest is based on reinvestment of interest for
the remaining subsequent period.
There are different types of cases are to be dealt in the situation of compound
interest. All these cases are discussed below.
(i) Compound value of a Single Amount :-
It is that case where one time investment at specified interest rate for speci-
fied period is done.
CV = P0 (1+I)N
Where CV = Compound Value
Illustration:- 2
Mr. Shukla has deposited R 50,000 with Y bank. This deposit would earn 8%
interest per annum. This deposit is made for the duration of 6 years.
(i) Calculate compound value of deposit.
CVN = P0 (1+I)N
= 50,000 (1+0.08)6
= 50,000 (1.587)
= R 79,350
Present Value Conditions Future Value
R 50,000 Duration of 6 years R 79350
Interest rate 8%
Result
R 50,000 × 1.587
51
BASICS OF Note:-
FINANCIAL The compound value 1.587 is obtained from the future value table.
MANAGEMENT
Manual Confirmation
Total
Particulars R1
Investment (R)
t0 Principal Amount 50,000 1.00
+t1 Interest @ 8% 4,000 0.08
54,000 1.08
+t2 Interest @ 8% 4,320 0.0864
58,320 1.1664
+t3 Interest @ 8% 4,666 0.0466
62,986 1.213
+t4 Interest @ 8% 5,039 0.0970
68,025 1.31004
+t5 Interest @ 8% 5,442 0.13729
73,467 1.44733
+t6 Interest @ 8% 5,877 0.115786
79,344 1.5631
So in the above question R 50,000 x 1.587 = R 79350. This is nearer to R
79344. Difference between R 79350 and R 79344 exists due to conversion of
fraction figure.
(ii) Different Compounding period:-
Generally the compounding period 1 year is used in practice. But this com-
pounding may be more than 1 time in a year. This compounding period may
be of two months, 3 months, 4 months and 6 months etc. The following
formula is used in this regard.
 I
CVn = P0 1   MN
 N
Wheren = Number of times per year compounding is done.
Illustration: - 3 (When half yearly compounding is given)
Shankar has deposited R 60,000 for the period of 6 years @ 6% and com-
pounding is done half yearly. Determine the amount which is receivable at the
end of 6th year.
Answer:-
 Int  MN
CVyth = P0 1 
 2 
 0.06  2 × 6
CV6th year = R 60,000 1 
 2 
= R 60,000 × 1.426
= R 85,560
52
Note: - 2 times × 6 years = 12 years & 6%/2 = 3% TIME VALUE
Illustration: - 4 (When quarterly compounding is given) OF MONEY
Shiva has deposited R 60,000 for the period of 6 years @ 8% and compound-
ing is done qaurterly. Determine the amount which is receivable at the end of
6th year.
Answer:-
 Int  MN
CVyth = P0 1 
 4 
 0.08  2×6
CV6th year = R 60,000 1 
 4 
= R 60,000 × 1.608
= R 96,480
Note: - Explanation for illustration no __3_ and ___4_.
In illustration no _3__duration is taken 12 years (half yearly for six years =
12) and interest rate is 3% (6% is yearly so half yearly 3%)
In illustration no___4_ duration is taken 24 years (quarterly for 12 years 4
quarter per year × 6 years) and annual interest rate is 2% (8% is yearly so
quarterly 2%)
Here both time period and interest rate are not in fraction. If any of them is in
fraction above stated method cannot be used and log and antilog calculations
1 1
are required. For e.g. duration in 3 years, 3 years etc and interest rate
2 4
4.25% 4.30% 4.75% etc.
4.2.3 Compounded Value of series of cash flow
(a) When cash flow takes place at the end of year:
Basically, the meaning of annuity is series of cash flows (in flow or out flow)
of a fixed amount for a specified period (number of years). The following
formula can be used to determine compound value of a series of uneven cash
inflow.
CVn = P1(1+I)n –1 + P2 (1+I) n –2 + ———Pn –1(1 + I) + Pn
Where CVn = Compound value at the end of ‘n’ year.
P1 = Payment at the end of year 1
P2 = Payment at the end of year 2
Pn = Payment at the end of year n
I = Interest
Illustration:-5
Ravi deposits stated amount at the end of respective year R 15,000, R 25,000,
R 20,000, R 10,000 and R 25,000 in this savings account in the year t1, t2, t3,t4,
t5. Interest rate is 8%.
What will be compound value of his deposits at the end of 5 yearsR
Answer:-
CVn = P1(1 + I)n –1 + P2 (1 + I)n –2 ———P 5(1 + I)0
53
BASICS OF = (15000) (1+0.08)4 + 25000(1+0.08)3 + 20,000(1+0.08)2
FINANCIAL +10,000(1+0.08)1 + 25000 (1+0.08)0
MANAGEMENT
= 15,000 (1.360) + 25,000 (1.260) + 20,000 (1.166) + 10,000 (1.080)
+10,000(1)
= 20,400 + 31,500 + 23,320 + 10,800 + 10,000
= 96,020
Substitute calculation method
Compounding
Annual No of times
Year factor (8%) Future value
Amount compounded (*)
(1) (2) (3) (4) (5)
t1 15,000 4 1.360 20,400
t2 25,000 3 1.260 31,500
t3 20,000 2 1.166 23,320
t4 10,000 1 1.080 10,800
t5 25,000 0 1 10,000
Total R 96,020
Confirmation cash flow of t1.
R
t1 15,000
+ int t2 1,200
16,200
+ int t3 1,296
17,496
+ int t4 1,400
18,896
+ int t5 1,511
20,407
In above calculation it is R 20,407 while manually it comes to R 20400. Since
it is invested from t1 onwards for first year compounded value is for 4 times.
* All values are obtained from future value interest factor (FVIF)
(b) When cash flow takes place in the beginning of the year.
CVn = P0(1+I)n + P1 (1+I)n –1 + P2(1+I)n –2 ——— Pn–1(1+I)+Pn
Illustration:-6
Mr. Raj deposits stated in the beginning of the respective year R 15,000, R
25,000, R 20,000, R 10,000 and R 25,000 in his savings account in the year t0,
t1,t2,t3 and t4. Interest rate is 8%.
What will be compound value of his deposits at the end of 5th year ?
Answer:-
CVn = P0(1+I)n + P (1+I)n –1 ————— P4(1+I)n –4
54
= 15000 (1+0.08)5 + 25000 (1+0.08)4 + 20,000 (1+0.08)3 TIME VALUE
+ 10,000 (1+0.08)2 + 25000(0.08)1 OF MONEY
= 15000 (1.469) + 25000 (1.360) + 20,000 (1.260)
+10000 (1.166) + 25000 (1.080)
= 22035 + 34000 + 25200 + 11660 + 27000
= R 1,19,895
Substitute calculation method
Cash out No of times Compounding Future
Year
flow (I) compounded factor value (I)
t0 15,000 5 1.469 22,035
t1 25,000 4 1.360 34,000
t2 20,000 3 1.260 25,200
t3 10,000 2 1.166 11,660
t4 25,000 1 1.080 27,000
Total R 1,19,895
Short cut formula
When the cash flows involves at the beginning of the year compound value
of annuity can be calculated with the following formula when even cash flow
is available.
 (1  I) n1 
CVn = P   (1+I)
 I 
Illustration: - 7
Ramakant deposit R 5000 at the beginning of every year for 6 years in
savings bank account at 6% compound interest. Calculate compounded value
at the end of 6th year.
 (1  0.06)6  1 
CV6 = 5000   (1+0.06)
 0.06 
How to determine the period to double the invested amountR
Under this head if specific amount is invested at specific rate of interest how
much time it will take to double the principal amount.
For this purpose two rules are used (i) Rule of 72 and (II) Rule of 69.
Formulas
Rule of 72 Rule of 69
DP = 72 ÷ I DP = 0.35+69/I
Where DP = Doubling period in years
I = Interest Rate
Rule 69 gives more precise period as compared to Rule 72.
55
BASICS OF Illustration:- 8
FINANCIAL Raman deposit R 5,000 today (t0) at 12% rate of interest in how many years
MANAGEMENT will this amount get doubleR
(i) Rule 72 = Dp = 72/I = 72/12 = 6 years
(II) Rule 69 = Dp =0.35+69/12 = 6.1 years
4.3 Present Value
Present value concept is exactly opposite to future value concept.
Future value is used to know the interest added to principal amount at a given
simple or compound value interest rate and given number of years. Under
future value concept the amount of future value is higher than amount in-
vested because future value is sum of principal and interest amount.
On the other hand present value concept is used to know the present value of
a sum that is receivable in future. Under present value concept the amount
present value is lower than the amount receivable after certain period of time
at certain percentage which is known as discount factor. The processes of
determining present value of a future cash flows (cash inflow or out flow) is
called discounting.
It is concerned with determining the present value of a future amount, assum-
ing that the decision maker has an opportunity to earn a specific return on his
investment. This rate of return is known in financial management as discount
rate, cost of capital, hurdle rate or opportunity cost.
The computations of present value in different situations are as follows:
4.3.1 Present Value of a Single Amount
In present value concept it is explained that how much to invest now to get an
amount on R 1 at the end of one year at specific discount rate.
The following formula is used to determine present value.
n
 1 
PV = FVn   or FVn [PVIFI – n ]
 (1  I) 
Where PV = Present Value
FVn = Future value receivable at the end of ‘R ’ years
I = Interest rate or discounting factor or cost of capital
n = Duration of cash flow
Or
FVn PVIFI–n
Illustration: - 9
An investor is expecting R 60,000 at the end of 3rd year @10% discount rate,
determine present value of future receivable amount of R 60,000.
Answer:-
 1 
PV = FV3  3
 (1  I) 
 1 3
= 40,000  
1  0.10 
56
Note: -Refer present value table and see present value of one rupee at 3 TIME VALUE
years for the rate of 10% and that is R 0.751. OF MONEY
= 40,000 × 0.751
= R 30,040
Explanation: - 10
The amount R 40,000 which will be received its present value is R 30,040
(aapprox). It means if R 30,040 invested at 10% for 3 years its value will be
R 40,000.
Present Value Conditions Future Value
R 30,000  Duration 3 years  R 30,000
Interest rate 10%
 
Result Process
40000 × 0.751
3.3.2 Present Value of series of cash flows
There are different forms of cash flows and we may need to calculate present
value of series of cash flows. For example in capital budgeting decisions,
future cash inflows are converted into present value to check the viability of
the project. These flows of cash can be even or uneven. So determination of
their present value is to be done with specific formulas.
(a) Present value of uneven cash flows: The following formula can be used:
CIF1 CIF2 CIFn
PV = 1 + 2 + ————— +
(1  I) (1  I) (1  I) n
Where: CIF1 and (1+I)1 indicates cash inflow at the end of first year and
present value rate at the end of first year and so on.
PV = Present Value, CIF = Cash in flow
I = Rate of Interest (Discount factor or cost of capital)
n = number of years
Illustration: - 11
From the following information, calculate the present value of cash inflows
at 10% interest rate.
Year 1 2 3 4 5
Cash inflow (R ) 10,000 12,000 9,000 10,000 11,000
Answer:-
10,000 12, 000 9, 000 10, 000 11, 000
PV = 1 + 2 + 3 + 4 +
(1  .10) (1  .10) (1  .10) (1  .10) (1  .10)5
10, 000 12, 000 9, 000 10, 000 11, 000

= + + + +
1.1 1.21 1.331 1.4141 1.6105
= 9090 + 9917 + 6762 + 6830 + 6830
= 39,429
57
BASICS OF Note:-
FINANCIAL Present value can also be calculated with help of present value formulas. But
MANAGEMENT present value tables are available for this calculation.
Here present value of one rupee @ 10% interest at the end of following year
will be as follows:
t1 t2 t3 t4 t5
0.909 0.826 0.751 0.683 0.621
Present Value
Year Cash Inflows PV factor (10%) Present Value

t1 10,000 0.909 9,090
t2 12,000 0.826 9,912
t3 9,000 0.751 6,750
t4 10,000 0.683 6,830
t5 11,000 0.621 6,831
Present Value 39,413
Note: - There is minor difference between calculated present value, which is

due to rounding of figures.
(2) Discount factor is calculated as follows:
FV
Formula PV =
(1  I) n
1 1
t1 = = = 0.909
 10  1.10
1  
 100 
1 1
t2 = = = 0.826
 10 
2
(1.10) 2
1  100 
 
and so on
(b) Present value of even cash flows: The formula would remain same.
CIF1 CIF2 CIF3 CIFn
PV = 1 + 2 + 3 ————— +
(1+I) (1+I) (1+I) (1+I)n
Illustration:- 12
From the following information calculate present value of cash inflow at 10%
interest rate.
Year 1 2 3 4 5
Cash inflow (R ) 12,000 12,000 12,000 12,000 12,000
58
12,000 12,000 12,000 12,000 12,000 TIME VALUE
PV = + 2 + 3 + 4 + OF MONEY
(1+.10)1 (1+.10) (1+.10) (1+.10) (1+.10)5
12,000 12,000 12,000 12,000 12,000

= + + + +
1.1 1.21 1.331 1.4641 1.6105
= 10909 + 9917 + 9016 + 8196 + 7451
= R 45,489
Alternative Method:-
Here present value of one rupee @ 10% interest at the end of following year
will be as follows:
t1 0.909, t2 0.826, t3 0.751, t4 0.683, t5 0.621
Year Cash Inflows (R ) PV factor (10%) Present Value
t1 12,000 0.909 10,908
t2 12,000 0.826 9,912
t3 12,000 0.751 9,012
t4 12,000 0.683 8,196
t5 12,000 0.621 7,452
Present Value 3.79 45,480
Alternative Method
Here the amount of cash inflow of each year is same so present value of
annuity 3.79 will be available from present value interest factor for annuity
(PVIFA)
Present Value = Annual Cash inflow (R ) × PVIFA
= 12000 × 3.79
= R 45,480
4.4 Sinking Fund Factor
Sinking fund is fund created to accumulate the specified amount of sum in a
future by way of regular periodic payment for some specific purpose. Basi-
cally here the problem involves the determination of amount of annuity for a
given future value aftera given period at a given rate of interest. The follow-
ing formula can be used.
FVA n  I 
Ap =  (1+I)n-1 
1  
Where: Ap = Annual payment
FVAn = Future value after ‘n’ years
I = Interest Rate
Illustration:- 13
Finance manager of a company wants to redeem debentures of R 10,00,000
at the end of 5th year. Its interest rate is 12% calculate annual payment re-
quired.
59
BASICS OF
FINANCIAL FVA n  I 
Ap =  (1+I)n-1 
MANAGEMENT 1  
.12
= 10,00,000
(1+.12)5  1
 .12 
= 10,00,000 ×  
1.7623  1 
 .12 
= 10,00,000 ×  
 7623 
= 10,00,000 × .1,57,406
= R 1,57,406 Annual payment required
Alternative Method
1
FutuerValue Interest factor
Ap = 10,00,000 ×
annuity @12% for 5 years
1
Ap = 10,00,000 ×
6.353
= R 1,57,406
Note: - Refer Future Value interest factors annuity @ 12% for 5 years, an-
swer is 6.353.
4.5 Loan Amortization
In banking and finance an amortizing loan is a loan where the principal of
loan is paid down over the life of the loan.
To determine amount of installment this is to be paid every year at specific
rate in certain period. The following formula is used.
 I(1  I)n 
LI = PA  (1  1)n1 
 
Where LI = Loan Installment
PA = Principal Amount
I = Interest Rate
R = number of years (loan repayment premium)
Illustration:- 14
Simaran Co. Ltd has raised loan of R 15,00,000 @ 9% interest per year. This
loan is to be repaid in six equal annual installments. Calculate the amount of
installments.
 I(1  I)n 
LI = PA  (1  1)n1 
 
60
TIME VALUE
 0.09(1  0.09)6 
= 15,00,000  (1  0.09)  1  OF MONEY
 
 0.09(1.677) 
= 15,00,000  
 (1.677)  1 
 0.15093 
= 15,00,000  
 0.677 
= 15,00,000 × .2229
= R 3,34,500
Alternate Method
PA
LI =
PVIFA
15,00,000
=
4.486
= R 3,34,374
Rounding off R 3,34,500
Check you progress
(1) The concept of ____________ is applicable to future value.
(a) Interest (b) Discount Factor
(2) The concept of ____________ is applicable to present value
(a) Interest (b) Discount Factor
(3) Purchasing power issue is concerned with ______.
(a) Future Value Theory (b) Present Value Theory
(4) Interest on Principal amount and interest is calculated under ______
(a) Simple Interest (b) Compound Interest
(5) Log and Anti-log is required to use to calculate compound valued
when _________fraction.
(a) Time period and interest rate are in
(b) Time period only is in
(6) ____________rule gives precise result to determine period to double
the invested amount
(a) Rule of 72 (b) Rule of 69
(7) Present value theory measures ___________
(a) Present value of rupee required in future
(b) Future value of rupee received in present
(8) Discount factor is known as ________
(a) Cost of capital (b) Interest rate
(9) For determination of regular period payment _________ is used.
(a) Sinking Fund Factor (b) Loan amortization
61
BASICS OF 4.6 Let us sum up
FINANCIAL
In Financial management both future value and present value are having
MANAGEMENT
uniform significance. Future value determination is done with the help of
interest component on the other hand present value determination is done
with the help of discount factor (cost of capital). Generally future value is
used for determination of income which will be received at a specific rate of
interest after specific period of time. Under this head we have studied com-
putation of simple interest, compounding interest and compound value of
series of cash flow. Present value is used in corporate form of business. Un-
der this head we have studied present value of single amount and present
value of series of cash flows. Apart from these two values sinking fund factor
and loan amortization are also studied for planning of repayment of bor-
rowed funds.
Check Your Progress
Answers: - (1-a), (2-b), (3-b), (4-b), (5-a), (6-b), (7-a), (8-a), (9-a)
4.8 Glossary
1. Future Value Theory: It is such theory where the amount is to be
received in future after certain period of time at a certain rate of inter-
est. This amount is to be received in future so theory developed for its
determination is known as future theory. Thus receivable future amount
is greater than present amount. To determine future value different
methods are used like simple interest, compound interest etc.
2. Present Value Theory: It is that theory which exactly opposite future
theory. Under this theory present value of rupee which is to be received
in future after certain period at a certain rate of return (discount rate) is
determined. This present value of amount receivable in future is always
less then future value. Under future value interest rate is important
component while for present value discount factor (cost of capital, op-
portunity cost) is important. To determine present value different situ-
ations are considered where present value of single amount, present
value of series of cash flow etc are computed.
4.9 Assignment
State different situation for determination of future value and present value.
4.10 Activities
(iii) How future value theory is different than present value of theory?
4.11 Case Study
Obtain the different loan schemes of any bank and calculate amount of loan
amortization.
1. Financial Management – P. C. Tulsian
Bharat Tulsian
2. Financial Management – Ravi Kishore
62
BLOCK SUMMARY
In this block we had a detailed discussion regarding basics of financial man-
agement and various sources of long term finance. Explanation in detail was
made in unit 1 on the main functions of financial management i.e. the role of
financial management, we also discussed the objectives of financial manage-
ment. The role of a finance manager is very crucial in the smooth running of
the organisation. He has to regularly monitor the finance condition of an
organisation. He has to calculate the amount of funds required very earlier so
that he can assure timely availability of the funds. He has to even find the
different sources through which funds can be raised. He has to properly take
care of availability of funds because in absence of funds the whole function-
ing of the organisation will come to halt. Apart from this in 2nd unit we dis-
cussed the various long term sources of finance through which the long term
needs of fund of an organisation can met easily. Unit 3 is prepared to explain
different short term sources of finance. For better understanding of us each
source of finance, their types. advantages and limitations are also explained.
these are two theories to determine value of investment. These theories are
future value and present value, both are explianed with appropriate
illustrations.
So in short this block gave a very detailed account of information regarding
finance and financial management.
BLOCK ASSIGNMENT
Short Answer Questions
Write short notes on
a. Maximization of Profit.
b. Role of Finance manager.
c. Objectives of financial Management.
d. Equity Capital
e. Term Loans
f. Debentures
Long Answer Questions
1. Explain the profit and wealth maximization concept.
2. Which should be given the importance in the long run?
3. Write a detailed note on long term sources of finance.
63
BASICS OF
FINANCIAL Enrolment No.:
MANAGEMENT
1. How many hours did you need for studying the unitse
Unit No. 1 2 3 4
Nos of Hrs
2. Please give your reactions to the following items based on your reading
of the block:
3. Any Other Comments

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
64
Ambedkar
OpenUniversity
BLOCK-2 COST OF CAPITAL, CAPITAL STRUCTURE AND

LEVERAGES
UNIT 1
COST OF CAPITAL
UNIT 2
CAPITAL STRUCTURE THEORIES
UNIT 3
ANALYSIS OF LEVERAGES
COST OF CAPITAL, BLOCK 2 : COST OF CAPITAL, CAPITAL STRUCTURE AND
CAPITAL STRUCTURE ANALYSIS OF LEVERGAES
AND LEVERAGES
Block Introduction
As we have already studied the importance of financial management in this curriculum
of management. Keeping in view of this we will move a little ahead to discuss few
of the very important topics of financial management.
This block is divided into three units. The units cover the topics cost of capital,
elements of cost of capital, capital structure, capital structure theories, all types of
leverages, like operating leverage, financial; leverage and total leverage. The unit
one will becovering the topic cost of capital in detail.It will explain the readers in
detail aboutthe various elements of cost of capital. Discussion shall also be made
on opportunity cost. Study shall also be made on the various factors that affect the
capital structure i.e whether the capital should contain equity or debt or in what
ratio the equity and debtbe maintained. In the second unit a detailed discussion
has been made on the various theories of capital structure. These theories have
been given regarding the composition of capital i.e what amount of capital should
be through the equity and what should be through debt. In the third unit different
types of leverages are explained with illustration. The role of leverage is also
explained.
After going through this detailed study the readers would be feeling it very interesting
and confident enough in this topic.
Block Objective
After reading this block, you will be able to understand :
• Trial balance and its limitations.
• Concept of cash capital.
• Classify cost of capital.
• Explain trading on enquiry.
• Enumerate and explain elements of cost of capital.
• Elaborate on opportunity cost of capital.
• The meaning of Capital Structure.
• Factors affecting the capital structure.
• Theories of capital structure.
• Realize how beta is related to capital structure.
• Explain adjusted present value.
• Operating leverage meaning, formula and risk associated with it
• Financial leverage meaning, formula and risk associated with it
• Total leverage meaning, formula and risk associated with it
Block Structure
Unit 1: Cost of Capital
Unit 2: Capital Structure Theories
Unit 3: Analysis of leverages
66
Unit COST OF CAPITAL
1
: UNIT STRUCTURE :
1.1 Introduction
1.2 Concept of Cash Capital
1.2.1 Definition
1.2.2 Importance
1.3 Elements of Cost of Capital
1.3.1 Cost of Equity
1.3.2 Cost of Retained Earnings
1.3.3 Cost of Preferred Capital
1.3.4 Cost of Debt
1.4 Classification of Cost of Capital
1.5 Opportunity Cost of Capital
1.6 Trading on Equity
1.7 Let Us Sum Up
1.8 Answers For Check Your Progress
1.9 Glossary
1.10 Assignment
1.11 Activities
1.12 Case Study
 Concept of cash capital.
 Classify cost of capital.
 About trading on enquiry.
 Enumerate and explain elements of cost of capital.
 Elaborate on opportunity cost of capital.
1.1 Introduction
The cost of capital is an important concept in formulating firm’s capital structure.
It is one of the cornerstones of the theory of financial management. The cost of
capital is an expected return that the provider of capital plans to earn on their
investment. It determines how a company can raise money (through a stock issue,
borrowing or a mix of the two). Cost of capital includes the cost of debt and the
cost of equity.
The main objective of business firm is to maximize the wealth of share holders in
long run. Capital (money) used for funding a business should earn returns for the
67
COST OF CAPITAL, capital providers who risk their capital. The management should only invest in
CAPITAL STRUCTURE those projects which give a return in excess of cost of funds invested in the projects
AND LEVERAGES of the business.
For an investment to be worthwhile, the expected return on capital must begreater
than the cost of capital. In other words, the risk-adjusted return on capital (that is,
incorporating not just the projected returns, but the probabilities of those projec-
tions) must be higher than the cost of capital. Difficulty will arisein determination of
cost of funds when it is raised from different sources and different quantum.
The cost of debt is relatively simple to calculate, as it is composed of the rate of
interest paid. In practice, the interest rate paid by the company will include the
risk-free rate plus a risk component, which itself incorporates a probable rate of
default (and amount of recovery given default). For companies with similar risk or
credit ratings, the interest rate is largely exogenous.
Cost of equity is more challenging to calculate as equity does not pay a set return
to its investors. Similar to the cost of debt, the cost of equity is broadly defined as
the risk-weighted projected return required by investors, where the return is largely
unknown. The cost of equity is therefore inferred by comparing the investment to
other investments with similar risk profiles to determine the “market” cost of eq-
uity. The cost of capital is often used as the discount rate, the rate at which pro-
jected cash flow will be discounted to give a present value or net present value.
1.2 Concept of Cash Capital
1.2.1 Definition
The cost of capital is the rate of return the company has to pay to various suppliers
of funds in the company. There is a variation in the costs of capital due to the fact
that different kinds of investment carry different levels of risk which is compen-
sated for by different levels of return on the investment.
In operational terms, cost of capital refers to the discount rate that would beused
in determining the present value of the estimated future cash proceeds and eventu-
ally deciding whether the project is worth undertaking or not. The cost of capital is
visualized as being composed of several elements. Elements are the cost of each
component of capital. The term ‘component’ means the different sources from
which funds are raised by a firm. The cost of each source or component is called
as specific cost of capital.
1.2.2 Importance
The cost of capital can be used as a tool to evaluate the financial performance of
top management. The actual profitability of the project is compared to the actual
cost of capital funds raised to finance the project. If the actual profitability of the
project is on the higher side when compared to the actual cost of capital raised,
the performance can be evaluated as satisfactory.
It is an important element, as basic input information in capital investment deci-
sions, in the present value method of discount cash flow techniques; the cost of
capital is used as the discount rate to calculate the NPV.
The cost of Capital acts as a determinant of capital mix in the designing of bal-
anced and appropriate capital structure.
The cost of capital can be used in making financial decision such as dividend
Policy capitalization of profit, rights issue and working capital, bonus issue and
capital structure.
68
The cost of Capital differs according to the situation. The different situations are COST OF
as follows:- CAPITAL
 Cost of existing debentures which are not redeemable but can be traded in
market.
 Cost of new debentures where there is a mention of flotation costs issue
expenses.
 Cost of Redeemable dentures.
 Cost of new ES where there is Floatation cost.
 Cost of new ES using capital asset Pricing Model(CAPM)
 Cost of new ES on the basic of realized Yield.
Weighted Average cost of capital (WACC) using book values as weights. WACC
using market values as weights
1. The ................... can be used as a tool to evaluate the financial perfor-
mance of top management
a. cost of capital
b. Capital structure
2. The cost of capital is .................. as being composed of several elements.
a. visualized
b. determinant
3. The actual profitability of the project is compared to the actual cost of
capital funds raised to ..................
a. finance the Report
b. finance the project
4. The cost of Capital acts as a determinant of capital mix in the designing of
................. and appropriate capital structure.
a. Capital
b. balanced
5. ...................... cost of capital (WACC) using book values as weights.
a. Weighted Average
b. High Average
1.3 Elements of Cost of Capital
Cost of Equity (KE)
Cost of Retained Earnings (Ke)
Cost of Preferred Capital (Kp)
Cost of Debt (Kd)
Explanation of all the above elements is as follows
1.3.1 Cost of Equity
The funds required for the project are raised from the equity share holders which
are of permanent nature. These funds need not be repayable during the lifetime of
the organization. Hence it is a permanent source of funds. The equity share hold-
ers are the owners of the company. The main objective of the firm is to maximize
69
COST OF CAPITAL, the wealth of equity share holders. Equity share capital is the risk capital of the
CAPITAL STRUCTURE company. If the company’s business is doing well the ultimate and worst sufferers
AND LEVERAGES are the equity share holders who will get the return in the form of ends from the
company and the capital appreciation from their investment. If the company comes
for liquidation due to losses, the ultimate and worst sufferersare the equity share
holders. Sometime they may not get their investment back during the liquidation
process.
Profits after tax less dividends paid out to the share holders, are funds, that belong
to the equity share holders which have been reinvested in the company and there-
fore, those retained funds should be included in the category of equity, or equity
may be defined as the minimum rate of return that a company on the equity fi-
nanced portion of an investment project so that market of the shares remain un-
changed.
Approaches
Fig 1.1 Approches

Dividend Method or Dividend Price Ratio Method
As per this method the cost of capital is defined as the discount rate that gets the
present value of ail expected future dividends per share with the net proceeds of
the sale (or the current market price) of a share.
This method is based on the assumption that the future dividends per share is
expected to be constant and the company is expected to earn at least this yield to
keep the share holders content.
D1
KE = P
E
Where,
KE = Cost of Equity
D1 = Annual Dividend per year
PE = Ex-dividend market price per share
Example:-
1. C ltd. has disbursed a dividend of R 18% on each equity share of R 10.Cur-
rent market price of share is R 12. Calculate the cost of equity as per divi-
dend yield method. Issue cost is 5% on face value.
Rs. 1.80
KE = × 100 = 15.65%
Rs. 11.50
D1
KE =
NP
70
(NP) i.e. Net proceeds per share COST OF
CAPITAL
(10,000 equity share × Rs. 12) - Rs. 5000
=
10,000 Equity Shares
Rs. 1,15,000
= = R 11.50 per share
10,000
Dividend Growth Model
When the dividends of the firm are expected to grow at a constant rate and the
dividend pay-out ratio is constant, this method may be used to define the cost of
equity capital based on the dividends and the growth rate.
D
KE = +G
NP
Where,
kE= Cost of equity capital
D = Expected dividend per share
G = Rate of growth in dividends
NP = Net proceeds per share
Further, in case, cost of existing equity share capital is to be calculated, the NP
should be changed with MP (market price per share) in the above equation.
Example:-
Loya Ltd. issues 2000 new equity shares of R 1000 each at par. The floatation
costs are expected to be 5% of the share price. The company pays a dividend of
R100 per share initially and the growth in dividends is expected to be 5%. Com-
pute the cost of new issue of equity share.
D
KE = +G
NP
10
= 1000 -50 + 5%
= 15.53 %
Price Earning Yield Model
This method takes into consideration the Earning per share (EPS) and the market
price per share. It is based on the argument tha teveniftheearningsarenot dis-
bursed as dividends, it is kept in the retained earnings and it causes future growth
in the earnings of the company as well as the increase in the market price of the
share. In calculation of cost of equity share capital, the earnings per share are
divided by the current market price.
E
KE =
M
Where,
E = Current earnings per share
M = Market price per share
71
COST OF CAPITAL, Example:
CAPITAL STRUCTURE Riya Ltd. has 50,000 equity shares of R10 each and its current market value is R
st
AND LEVERAGES 45 each. The after tax profit of the company for the year ended 31 march 2020
is R 9,60,000. Calculate the cost of capital based on price / earning method
Rs. 9,60,000
Calculation of EPS = = R 19.20
50,000 no ES
E Rs. 19.20
KE = = = 0.42 67 or 42.67%
M Rs. 45
Capital Asset Pricing Model (CAPM)
The CAPM divides the cost of equity into two components, the near risk- free
return available on investing in government bond and an additional riskpremium
for investing in a particular share or investment. The risk premium in turn com-
prises average return of the overall market portfolio and the beta factor (or risk) of
the particular investment, putting this all together the CAPM assesses the cost of
equity for an investment, as the following:
KE = Rf + Bi (Rm – Rf)
Where
Rf = Risk free rate of return
Rm = Average market return
Bi = Beta of the investment
Example
Rohan Ltd: share beta factor is 1.40. The risk free rate of interest on government
securities is 9%. The expected rate of return on company equity shares is 16%.
Calculate cost of equity capital based on capital asset pricing model
K E = 9% + 1.40 (16% - 9%)
= 9% + 1.40 (7%)
= 9% + 9.8% = 18.8%
The appropriate discount rate to apply to the forecasted cash flows in an invest-
ment appraisal is the opportunity cost of capital for that investment. The opportu-
nity cost of capital is the expected rate of return offered in the capital markets for
investments of a similar risk profile. Thus it depends on the risk attached to the
investments cash flows.
1.3.2 Cost of Retained Earnings
The retained earnings are one of the major sources of finance available for the
established companies to finance its expansion and diversification programmes.
These are the funds accumulated over the years by the company bykeeping part
of the funds generated without distribution. The equity share holders of the com-
pany are entitled to these funds and sometimes these funds are also taken into
account while calculating the cost of equity. But so long as the retained profits are
not distributed to the share holders, the company can use the funds within the
company for further profitable investment opportunities.
The cost of retained earnings to the share holders is basically an opportunity cost
of such funds to them. It is equal to the income that they would otherwise obtain
by placing these funds in alternative investment.
72
KR = KE (1 – T) COST OF
Where, CAPITAL
KR = Cost of Retained earnings
KE = Cost of Equity Capital
T = Tax rate of Individuals
Example:-
The Cost of E/s capital of S Ltd. is 24%. The personal taxation of individual share
holders is 30%. Calculate the cost of retained earnings.
KR = KE (I – T)
= 24% (1 – 0.30%)
= 24% (1 – 0.30)
= 16.8 %
1.3.3 Cost of Preferred Capital
The cost of preference share capital is the dividend expected by its investors.
Moreover, preference share holders have a priority in dividend over the equity
share holders. In case dividends are not paid to preference share holders, it
willaffect the fund raising capacity of the firm. Hence dividends are usually paid
regularly on preference shares except when there are no profits to pay dividends.
The cost of preference can be calculated as
D
KP =
P
Where,
KP = Cost of preference capital
D = Annual preference dividend
P = Preference share capital (Proceed)
When preference shares are issued at premium or discount or when cost of flota-
tion is incurred to issue preference share, the nominal or par value of preference
share capital has to be adjusted to find out the net proceeds from the issue of
preference shares.
D
KP =
P
Example
Spice jet airlines issued 20,000 10% preference share of R 100 each. Cost of
issue is R2 per share. Calculate cost of preference capital if these shares are
issued (a) at premium of 10%. (b) at a discount of 5%.
D
– Cost of Preference Capital, KP =
NP
2,00,000
(A) KP = 100
20,00,000 - 40,000
2, 00, 000
= × 100 = 10.2%
19, 60, 000
73
COST OF CAPITAL, 2, 00, 000
CAPITAL STRUCTURE (B) KP = 20, 00, 000  2, 00, 000  40, 000 × 100
AND LEVERAGES
= 2,00,000 × 100 = 9.26%
= 21,60,000
D
– Cost of Preference Capital, KP =
NP
2, 00, 000
(C) KP = 20, 00, 000  1, 00, 000  40, 000 × 100
2, 00, 000
= × 100 = 10.75%
18, 60, 000
Cost of Redeemable Preference shares:
 Rv 
D   Sv 
 N 
 Rv  Sv 
 
 2 
Kp Cost of preference shares
D = Constant annual dividend payment N = No. Of years to redemption
R = Redeemable value of preference shares at the time of redemption,
S = Sale out value of preference shares less discounts floatation expenses
Example:-
 Rv  Sv 
D 
 N 
KP =
 Rv  Sv 
 
 2 
D = Coupon rate i.e. R 12
N = Years to redemption i.e. 15 yrs.
R = Redeemable value with 10% premium i.e. R 110
S = Sale Value (Nominal value - discount – flotation cost)
i.e. R 1000- R 5- R 5 =90.
 110  90 
12   
 15 
KP =  110  90 
 
 2 
 12  1.33  13.33
=  = = 0.13.33 or 13.33%
 100  100
74
1.3.4 Cost of Debt COST OF
The cost of debt is the rate of interest payable on debt capital obtained through CAPITAL
the issue of debentures. The issue of debentures involves a number offloatation
charges, such as printing of prospectus, advertisement, underwriting, brokerage
etc. Again, debentures can be issued at par or at timesbelow par (at discount) or
at times above par (at premium).
The cost of debt capital is given as
1
Kd =
P
Where,
Kd = Cost of debt (before tax)
I = Interest
P = Principal
Where debentures are issued at premium or at discount, the formula:
I
Kd =
NP
Where,
Np = net proceeds
The after tax cost of debt may be calculated as–
After tax cost of debt = Kd(1-t)
Where, t is the tax rate.
Example:
ABC Ltd. Issues R 50,000, 8% debentures at a premium of 10%. The tax rate
applicable to the company is 30% compute the cost of debt capital.
I
Kd = (1 – t)
NP
4,000
= (1 – 0.3)
50,000
4,000
= ( 0.7)
50,000
= 5.60%
Practical Problems with Solutions: Question:
A Company issues 10% Debentures of R 100/- each at par. Cost of Issue (also
known as Floatation Cost) is 3% of the issue price. Calculate Kd (Cost of De-
benture) if applicable tax rate is 40%.
Solution:
Interest (1- t)× 100
Kd =
Proceeds of a Debenture
6 × 100
=
97
= 6.18%
75
COST OF CAPITAL, Before Tax
CAPITAL STRUCTURE
Interest × 100
AND LEVERAGES Kd =
Proceeds of a Debenture
10 × 100
=
97
= 10.31%
10.31% less Tax 40% i.e. 4.12 = 6.18%
Cost of Debenture newly Issued and Redeemable
Question:
A company issued R 100 /- Debenture at par carrying coupon rate of 10%. Cost
of issue was 3%. Debentures are redeemable at par after 6 years. Calculate K
(Cost of Debenture) assuming that issue cost cannot be claimed as tax deductible
expenses. Applicable Tax Rate is 30%. Calculate the Cost of Debentures.
Solution.
This Question can be answered in 2 ways:
Interest (1- t) + Annualized loss on Issue
a) Approximate Kd = × 100
Average Value of Debentures
= 97 + 100/2 = 98.5
= 7 + 0.5 × 98.50
= 7.614%
Rs.3
Note : Annualized loss = = Yearly R 0.5
6 years
b) We can calculate more precisely Kdis when we calculate the Internal Rate
Return or
Rate of Discount at which Net Present Value of Cash Flows associated with the
Debenture has Zero ‘0’ NPV.
With the help of the NPV know we shall find out the Internal Rate of Return
(IRR):
1% change (from 7% to 8%) gave a change of 4.601
?% change will give change of 2.962
1 × 2.962 = 0.644%
4.601
There fore, IRR = 10.644% which is the Cost of Debenture.
Question:
A company issues R 100/- Preference Shares at a Discount of 2%. Preference
Shares are redeemable after 6 years at a Premium of 3%. Coupon Rate is 10%.
Calculate KP (Cost of Preference Capital) as precisely as possible.
Solution
We will have to calculate the Internal Rate of Return (IRR) but to know the ap-
proximate range within which the IRR will lie we need to calculate the approxi-
mate KP first:
76
a) Approximate KP = 10 + 5 COST OF
6 × 100 CAPITAL
98 +103
Kp = 10.776
Pre. sh. divi. + Annualise loss on issue and redemption
Kp =
Average value of share
98 + 103
Avarage value of shares = = 100.50
2
3
Annualized loss = 2 + = 0.833
6
10 + 0.8333
= × 100
100.5
We have known the Range is between 10% and 11% so we can calculate NPV
and further with the help of NPV we shall find out the Internal Rate of Return
(IRR).
1% change (from 10% to 11%) gave a change of 4.207
?% change will give change of 3.622b
Therefore, the Internal Rate of Return (IRR) = 10.861% which is the Cost of
Preference Capital.
Problems for Practice
1. Capital structure of a company is as follows:
12%termloan R 3 crores
Equity capital R 2 crores
Retained earnings R 4 crores
Earnings per share and dividend have steadily grown @ 6%. The same growth
rate is expected to continue in future also. Market price per share is R 40. The tax
rate is 60%. Calculate the WACC of the company.
2. Capital structure of a company in terms of market value is as under:
LoansR 3 crores
Equity R 6 crores
Additional R 1.5 crores is to be invested next year. Current price of equity share
is R 30 but additional equity shares can be issued at R 25 per share.
Additional investment of R 1.5 crores has to be raised as follows:
Retaine dearnings R 0.5 crores
Fresh equity R 0.5 crores
14% loan R 0.25 crores
15% termloan R 0.25 crores
Applicable tax rate is 60%.The expected rate of dividend grow this 5%. The
additional investment is so planned that at each stage the existing debt- equity
ratio should remain unchanged. Calculate marginal cost of capital of each chunk.
77
COST OF CAPITAL, 3. Book value of capital structure of a company is as follows:
CAPITAL STRUCTURE 10 lakh equity shares of R10 each 100 lakhs
AND LEVERAGES 10,000 11% preference shares of R100each 10 lakhs
Retained earnings 120 lakhs
13.5% debentures 50 lakhs
12% termloan 80 lakhs
Next equity dividend will be R 1.5. This will grow at 7% annually. The market
price per share is R 20/-. The preference shares redeemable after 10years have a
current market value of R 75.Debentures redeemable after 6 years are selling at R
80. The tax rate of the company is 50%.Calculate:
 Existing WACC using book value proportions
 Existing WACC using market value proportions
4. Consider a company whose details are furnished in question 3 above. It
wishestoraise R100 lakhs from equity and debt in equal proportions.
Retained earnings to be used are R 15 lakhs. Fresh equity can be issued at R 16
per share. First R 25 lakhs can be borrowed at 14% and next R 25 lakhs at 15%.
Calculate marginal cost of capital.
Assumptions of Cost of Capital
Assumptions:
Following assumptions underlying the analysis of cost of capital
 Each new investment is deemed to be financed from a pool of funds in
which the various sources of long-term financing are represented in the
proportions in which they are found in the capital structure. For example,
suppose the proportions of equity and debts in the capital structure of a firm
are equal. The firm is planning to undertake two investments, in projects 1
and 2 each requiring an outlay of R 200 lakhs. The total financing required
is R 400 lakhs and this will be raised by issuing equity stock anddebentures
to the extent of R 200 lakhs each. However, because of some ‘lumpiness’ in
the process of financing, the firm would first raise R 200 lakh of equity
financing at the time when project 1 is undertaken and then it would raise R
200 lakhs of debt financing when project 1 is undertaken. According to the
pool financing assumption, each process k deemed to be financed by a
mixture of equity and debt in equal proportion, though the specific financing
sought at the time of undertaking 1, is only equity and at the time of under-
taking 2 is only debt.
 The risk characterizing new investment proposals being considered is the
same as the 5 risks characterizing the existing investment of the firm. In
other words, the adoption of new investment proposals will not change the
risk complexion of the firm.
 The capital structure of the firm will not be affected by the new investments.
This means that the firm will continue to pursue the same financing policies.
 In general, if the firm uses n different sources of finance, the cost of capital
is where, kaAverage cost of capital
Pi = Proportion of P source of finance
K = Cost of the first source of finance
78
Check your progress 2 COST OF
1. The ................. are one of the major sources of finance available for the CAPITAL
established companies to finance its expansion and diversification
programmes.
a. dividends
b. shares
c. retained earnings
2. The ................ of the firm will not be affected by the new investments.
a. Firm Structure
3. The cost of debt is the rate of interest payable on………….. obtained
through the issue of debentures.
a. Debt capital
b. Cost of capital
4. The cost of preference share capital is the dividend expected by its ..........
a. Supplier
b. investors
5. The funds required for the project is raised from the .................... which
are of permanent nature.
a. Equity share holders
b. Preference Shareholder
1.4 Classification of Cost Capital
Classification
Cost of capital can be classified in different ways. Some of them are given below:
1. Explicit cost and Implicit cost
2. Historical cost and Future cost
3. Cost of Capital and Capital Structure
4. Specific cost and Composite cost
1. Explicit cost and implicit cost: Explicit cost refers to the discount rate
which equates the present value of cash inflows with the present value of
cash outflows. Thus, the explicit cost is the internal rate of return which a
company pays for procuring the required finances.
Implicit cost represents the rate of return which can be earned by investing
the capital alternative investments. The concept of opportunity cost gives
rise to the implicit cost. The implicit cost represents the cost of the oppor-
tunity foregone in order to take up a particular project. For example, the
implicit cost of retained earnings is the rate of return available to the share
holders by investing the funds elsewhere. Computation of implicit cost of
debt: There are certain costs, besides the actual interest entailed by the
debt but the company does not take note of it since it is not incurred di-
rectly. With induction of additional dose of debt beyond certain level the
company may run the risk of bankruptcy. The share holders may react to it
strongly and in consequence, the share prices may tend to nose-dive. There
may be further setback to share values caused by increased instability of
79
COST OF CAPITAL, earnings consequent upon unfavourable leverage. The lossin shares values
CAPITAL STRUCTURE owing to increased risk and greater instability of earnings is termed as im-
AND LEVERAGES plicit cost or invisible cost of debt capital.
Thus, with increase in doses of debt, investors will demand higher interestrate
because of the increased risk. Alongside in explicit cost, the implicitcost will
also tend to riseas the company will beable to sell bond at lower price.
To arrive at the actual cost of debt capital, hidden or implicit cost should be
added in the explicit cost. But the problem lies in computation of the implicit
cost of capital.
2. Historical cost and future cost: Historical cost represents the cost which
has already been incurred for financing project. It is computed on the basic
of past data collected. Future cost represents the expected cost of funds to
be raised for financing a project. Historical cost is significant since it helps in
projecting the future cost and in providing an appraisal of the past financial
performance by comparison with the standard or predetermined costs. In
Cost Of Capital financial decisions, future costs are more relevant than the
historical costs. Historical costs are only of historical value and not useful
for cost control purposes.
3. Specific cost and composite cost: Specific cost refers to the cost of a
specific source of capital while composite cost of capital refers to the com-
bined cost of various sources of capital. It is weighted average cost of
capital which is also termed as overall cost of capital. When more than one
type of capital is employed in the business, it is the composite cost which
should be considered for decision-making and not the specific cost. But
where one type of capital is employed in the business, the specific cost of
that capital alone must beconsidered.
4. Average cost and marginal cost: Average cost of capital refers to the
weighted average cost calculated on the basic of cost of each source of
capital and weights assigned to them in the ratio of their share to capital
funds. Marginal cost of capital refers to the average cost of capital which
has to be incurred to obtain additional funds required by a firm. Marginal
cost of capital is considered as more important in capital budgeting and
financing decisions. A ctually, marginal cost is the total of variable cost.
Weighted Cost of Capital
The weighted average cost of capital is termed “as the average cost of the com-
pany’ s finance (equity, debentures, bank loans) weighted according to the pro-
portion each element bears to the total of capital weightings usually based on
market valuations, current yields and costs after tax”.
80
Capital Structure and Dividend Decisions COST OF
CAPITAL
Fig 1.2 Capital Structure and Dividend Decisions

Cost of capital is the overall composite cost of capital and may be defined as the
average of the cost of each specific fund. Weighted average cost of capital
(WACC) is defined as the weighted average of the cost of various sources of
finance, weight being the market value of each source of finance outstanding.
Cost of various sources of finance refers to the return expected by the respective
investors. A firm may procure long-term funds from various sources like equity
share capital, preference share capital, debentures, term loans etc. at different
costs depending on the risk perceived by the investors. When all these costs of
different forms of long-term funds weighted by their relative proportions to get
overall composite cost of capital, it is termed as ‘weighted average cost of capital
(WACC)’ . The firm’s WACC should be adjusted for the risk characteristics of a
project for which the long-term funds are raised. Therefore, project’ s cost of
capital is WACC plus risk adjustment factor. The argument in favor of using WACC
stems from the concept that investment capital from various sources should be
seen as a pool of available capital for all the capital projects of an organization.
Hence cost of capital should be weighted average cost of capital. Financing deci-
sion, which determines the optimal capital mix, is traditionally made without mak-
ing any reference to WACC. Optimal capital structure is assumed at a point where
WACC is minimum. For project evaluation, WACC is considered as the mini-
mum rate of return required from project to pay off the expected return of the
investors and as such WACC is generally referred to as the required rate of
return’ . The relative worth of a project is determined using this required rate of
return as the discounting rate. Thus, WACC gets much importance in both the
decisions.
Simple WACC - The simple WACC is calculated without consideration to the
impact of tax on cost of capital. The combined cost of equity capital and debt
capital is the WACC for a company as whole. If the company is all equity fi-
nanced, the cost of equity willbe the cost of capital. In case of geared companies,
the WACC can be stated as follows:
WACC = (Cost of Equity X Propostion of Equity) + (Cost of Debt X % Propor-
tion of Debt)
Illustration 1
Good Health Ltd. has a gearing ratio of 30%. i.c. debits 30% and equity is 70%.
The cost of equity is computed at 21% and the cost of debt 14%. The corporate
tax rate is 40%. Calculate WACC of the company.
81
COST OF CAPITAL, WACC = (21% X 0.70) + [14% (1 - 0.40) X 0.30] - 14.70% + 2.52% - 17.22%
CAPITAL STRUCTURE single corporate for is given so cost of debts is post tax.
AND LEVERAGES Check your progress 3
1. .................. cost represents the cost which has already been incurred for
financing project.
a. Implicit
b. Future
c. Explicit
d. Historical
2. Cost of capital is the overall composite cost of capital and may be defined
as the average of the cost of each specific ......................
a. Bonus
b. Fund
3. Historical cost represents the ................. which has already been incurred
for financing project.
a. Cost
b. Share
4. Implicit cost represents the ............... which can be earned by investing the
capital alternative investments.
a. Rate of investment
b. rate of return
5. Investors will demand ...................... rate because of the increased risk.
a. Higher interest
b. Lower interest
1.5 Opportunity Cost of Capital
When an organization faces shortage of capital and it has to invest capital in more
than one project, the company will meet the problem by rationing the capital to
projects whose returns are estimated to be more. The firm might decide to esti-
mate the opportunity cost of capital in other projects.
Illustration 2
Western Ltd. has got two project proposals A and B in hand with limited re-
sources to take up one out of it. The estimated returns on capital employed of two
projects are 15% and 18% respectively.
The opportunity cost of capital for taking up Project A is 18%, since if the funds
are invested in Project B, the company will get 18% return on invested funds.
Hence, expected return on Project B is the opportunity cost of capital for
Project A.
Another approach to opportunity cost of capital concept is that the expected rate
of return equates to the market interest rate for investments of a similar risk profile.
While discounting the risky cash flow sat different rates, the companies will take
into consideration different risk premium for different types of investments de-
pending on the nature of investment. This is usually in the form of premium on what
is considered the basic company cost of capital. The opportunity cost of funds can
be analyzed from the following two angles:
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Opportunity Cost of Equity Funds COST OF
If a company cannot earn sufficient profits, share holders will be dissatisfied. The CAPITAL
company will not beable to raise funds from new issue of shares, because inves-
tors will not be attracted. Existing share holders who wish to sell their shares will
find that buyers, who can invest in whatever securities they choose, will offer a
comparatively low price, and the market price of the shares will be depressed.
Since investors have added range of shares available to them there is a market
opportunity cost of equity funds.
Opportunity Cost of Debt Funds
Financial management is concerned with obtaining funds for investment, and in-
vesting those funds profitability as to maximize the value of the firm. It is not
enough to invest for profit, it is necessary to invest so that the profits are sufficient
to pay lenders a satisfactory amount of interest. If a company cannot pay interest
at the market rate demanded by lenders, the lenders will prefer to invest else-
where in the capital market, where they can get this rate. There is a market op-
portunity cost of debt funds which a company must expect to pay for new fi-
nance.
Marginal Cost of Capital
Firms calculate cost of capital in order to determine a discount rate to use for
evaluating proposed capital expenditure projects. The cost of capital is measured
and compared with the expected benefits from the proposed projects. The mar-
ginal cost of funds is the cost of the next increments of capital raised by the firm.
The costs of additional individual components of finance like shares, debentures,
term loans etc. should be ascertained to determine its weighted marginal cost of
capital. The new capital projects should be accepted if they have a positive net
present value calculated after discounting the revenue and cost streams at mar-
ginal cost of capital to the firm. Emphasis is being placed on marginal cost of
capital, for it is used as a cut off point for new investments. The concept of mar-
ginal cost of capital is based on economic theory that a firm should undertake a
project whose marginal revenues are in excess of its marginal costs. When the
capital investment decisions are taken in consonance of this principle, share holder’
s wealth is maximized. The weighted average cost of capital (WACC) of the firm
is not relevant for making new (marginal) resource allocation decisions. All the
projects that have an internal rate of return greater than its marginal cost of capital
would be accepted. Only when the returns of a particular project is in excess of
its marginal cost of capital, can add to the total value of the firm. The marginal cost
of capital of additional finances of a new project will reflect the changes in the
total weighted average cost of capital structure, after the introduction of new
capital into the existing capital structure.
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COST OF CAPITAL, Investment Appraisal and WACC
CAPITAL STRUCTURE
AND LEVERAGES
Fig 1.3 Investment Appraisal and WACC

The cost of capital is a market determined rate of interest, and is the discount rate
or required rate of return which is used for discounting cash flows in investment
appraisal calculations. The overall investment of a firm, in different projects can be
invested, so long as its internal rate of return is above its WACC.
Figure illustrates that the firm can invest in projects A, B, C and D because their
returns exceed the firm’s cost of capital. The firm’s value is maximized by selection
of project A, B, C and D. Projects E and F should be rejected, otherwise the
value of the firm will be diminished.
Marginal Cost of Capital and WACC
The relationship between marginal cost of capital (MCC) and weighted average
cost of capital (WACC) is explained in Figure. While MCC is less than WACC,
the WACC will fall. When MCC raise above WACC, the WACC will also show
an increase, but the rate of increase is lesser than the rate of increase of MCC.
Fig 1.4 Marginal cost of capital and WACC - Relationship
84
Illustration 3 COST OF
A company is considering raising of funds of about R100 lakhs by one of two CAPITAL
alternative methods, viz., 14% institutional term loan and 13% non- convertible
debentures. The term loan option would attract no major incidental cost. The
debentures would have to be issued at a discount of 2.5% and would involve cost
of issue of R 1 lakh. Discount and issue costs are too debentures.
Advise the company as to the better option based on the effective cost of capital
in each case. Assume a tax rate of 50%. (C.A. Final Nov. 1991)
Comparative Statement
(Funds required R 100 Lakhs)
Option
Particulars 14% Term 10% converti?le
loan de?entures
Face value 100 100

Less : Interest - 1
Less : Discount - 2.50
Net Realization 100 96.50
1 14 13.
(1 - t) (1.50) (1056)
p 100 96.50
7% 6.74%
The main aim of business unit is to maximize the wealth of the firm and increase
returns to the equity holders of the company. ‘Trading on equity’ helps the finance
manager to select an appropriate mix of capital structure. Equity has the cost of
expectations of the holders, preference capital has the cost of dividends and pub-
lic deposit has the cost of interest. Therefore, it is the necessity to reduce the
weighted average cost to be minimum through which a firm can increase the re-
turn to equity share holders.
Trading on equity is the financial process of using debt to produce gain for the
residual owners. The practice is known as trading on equity because it is the
equity share holders who have only interest (or equity) in the business income.
The term bears its name also to the fact that the creditors are willing to advance
funds on the strength of the equity supplied by the owners. Trading feature here is
simply one of taking advantage of the permanent stock investment to borrow
funds on reasonable basic. When the amount of borrowing is relatively large in
relation to capital stock, a company is said to be ‘trading on this equity’ but where
borrowing is comparatively small in relation to capital stock, the company is said
to be ‘trading on thick equity’.
The term leverage refers generally to circumstances which bring about an in-
crease in income volatility. In business, leverage is the means through which
abusiness firm can increase the profits. The force will be applied on debt; the
benefit of this is reflected in the form of higher returns to equity share holders. It is
termed as Trading on Equity’ .
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COST OF CAPITAL, Check your progress 4
CAPITAL STRUCTURE 1. The ................. is measured and compared with the expected benefits from
AND LEVERAGES the proposed projects
a. return on capital.
b. interest on capital
c. cost of capital
2. The term leverage refers generally to circumstances which bring about an
....................... in income volatility
a. increase
b. Decrease
3. Trading on equity is the financial process of using debt to produce
....................... for the residual owners.
a. Loss
b. gain
4. Firms calculate ....................... in order to determine a discount rate to use
for evaluating proposed capital expenditure projects
a. Cost of share
b. cost of capital.
5. If a company cannot earn sufficient ......................., share holders will be
dissatisfied
a. Profits
b. Loss
1.6 Trading on Equity
‘Trading on Equity’ acts as a level to magnify the influence of fluctuations in earn-
ings. Earnings per share are abarometer through which performance of an indus-
trial unit can be measured. This could be achieved by applying the operation of
trading on equity. Any fluctuation in earnings before interest and tax (EBIT) is
magnified on the earning per share (EPS) by operating trading on equity. It was
observed that larger the magnitude of debt in capital structure, the higher is the
variation in EPS given and variation in EBIT.
The effects of trading on equity can be clearer with the help of following illustra-
tion.
Illustration 4
Shriram Company is capitalized with R 10,00,000 dividend in 10,000 common
shares of R 1.00 each. The management wishes to raise another R 10,00,000 to
finance a major programme of expansion through one of the possible financing
plan. The management may finance the company with
1. All common stock (Equity share capital)
2. R 5 lakhs in common stock and R 5 lakhs in debt @ 5%
3. All debt at 6% interest or
4. R 5 lakhs in common stock and R 5 lakhs in preferred stock (preference
share capital) with 5 per cent dividend. The company’ s existing earnings
before interest and taxes (EBIT) amounts to R120,000. Corporation tax is
assumed to be 50%.
86
Solution: COST OF
Impact of trading on equity, as observed earlier, will be reflected in earnings per CAPITAL
share available to common stockholders. To calculate the EPS in each of the four
alternatives, EBIT has to be first of all calculated:
Proposal Proposal Proposal Proposal
(A) R (B) R (C) R (D) R
Earnings before interest & 1,20,000 1,20,000 1,20,000 1,20,000
Taxes (EBIT)
Less: Interest ------- 25,000 60,000 -----
Earnings before Taxes 1,20,000 95,000 60,000 1,20,000
Less: Taxes @50% 60,000 47,500 30,000 60,000
Earnings after Taxes 60,000 47,500 30,000 60,000
Preferred stock dividend ---- ---- ---- 25,000
Earnings available to common 60,000 47,500 30,000 35,000
stockholders
Number of common share 20,000 15,000 10,000 15,000
Earning per share (EPS). R 3.0 R 3.67 R 3.0 R 2.33
It is evident from the above example that, proportion of common stock intotal
capitalization is the same in both the proposals ‘B’ and ‘D’ but EPS is altogether
different because of addition of preference stock. While preferred stock dividend
is subject to taxes whereas interest on debt is tax deductible expenditure resulting
in variation in EPS in proposal ‘B’ and ‘D’ . It is also observed that, with a 50%
tax rate the explicit cost of preferred stock is twice the cost of debts: When EBIT
is R 1,20,000 proposal ‘B’ involving a total capitalization of 75% common stock
and 25% debt, would be most preferable with respect to EPS.
It is generally accepted that level of earnings would remain the same even after the
expansion of funds. Now let us assume that level of earnings before interest and
tax (EBIT) increased 100% or exactly doubles the present level (i.e. R 2,40,000
in case of above example) in correspondence will increase in capitalization. Changes
in earning per share (EPS) to common stockholders under different alternative
proposals would be as follows –
87
COST OF CAPITAL, Illustration 5
CAPITAL STRUCTURE Proposal Proposal Proposal Proposal
AND LEVERAGES (A) R (B) R (C) R (D) R
Earnings befo re interest & 2,40,000 2,40,000 2,40,000 2,40,000
Taxes (EBIT)
Less: Interest ------- 25,000 60,000 -----
Earnings befo re Tax es 2,40,000 2,15,000 1,80,000 2,40,000
Less: Taxes 1,20,000 1,07,500 90,000 1,20,000
Earnings after Taxes 1,20,000 1,07,500 90,000 1,20,000
Less: Preferred stock dividend ---- ---- ---- 25,000
Earnings available to com mon 1,20,000 1,07,500 90,000 95,000
stockholders
Number of common share 20,000 15,000 10,000 15,000
Earning per sh are (EPS). R 06 R 7.17 R 09 R 6.23
EPS before additional issue R 03 R 3.17 R 03 R 2.33
It is observed from illustration that increase in EBIT is magnified on the earning per
share (EPS) where debt has been inducted. Since dividend on preferred stock is
a fixed obligation and is less than the increased earnings, EPS in proposal ‘D’
increases more than twice the rise in earnings. On the other hand, in proposal ‘B’
and ‘C’ where debt comprises a portion of total capitalization, EPS would in-
crease by more than twice the existing level, while in proposal ‘A’ , EPS has
improved exactly in proportion to increase in EBIT.
It is also observed from the above example that larger the ratio of debt to equity,
greater is the return to equity. Thus in proposal ‘C’ debt represents 50% of the
total capitalization. EPS is magnified 3 times over the existing level while in pro-
posal ‘B’ where debt has furnished 1/3 of the total capitalization, increase in EPS
is little more than double the earlier level. This quickly changing of earning oper-
ates during a contraction of income as well as during an expansion.
Magnification of losses by trading on equity: Trading on equity not only acts as a
level to magnify the influence of fluctuations in earning but trading on equity mag-
nifies all losses sustained by the business concern. For example, assume that the
Delhi company expects to sustain loss of R 30,000 before interest and taxes, loss
per share under the different alternative proposals (as taken into consideration in
above would be as follows :
Illustration 6:
Proposal Proposal Proposal Proposal
(A) R (B) R (C) R (D) R
Loss before interest - 30,000 -30,000 -30,000 -30,000
and taxes
Add: Interest -25,000 -60,000
Loss after Interest -30,000 -55,000 -90,000 -30,000
Loss per share - R 1.50 - R 3.57 - R 09 - R 02

88
The important conclusion that could be drawn from the above illustration is that, COST OF
loss per share is highest under alternative ‘C’ where proportion of debt is as high CAPITAL
as 50% of the total fund and the lowest in proposal ‘A’ where leverage is zero.
This example proved that trading on equity magnifies not only profits but losses
also.
Use of ‘trading on equity’ : A magic of trading on equity is that trading on equity
magnifies both profit and loss. A trading on equity is useful as long as the bor-
rowed capital can be made to pay the business more than what it costs. It will
lead to a decrease in profitability rate when it costs more that it earns.
1. ................. is a barometer through which performance of an industrial unit
can be measured
a. Price per share
b. Return on share
c. Earnings per share
2. Any fluctuation in is magnified on the earning per share (EPS) by operating
trading on Equity
a. earnings before interest and tax
b. Earning after interest and tax
3. Trading on Equity quickly changing of ................. operates during a con-
traction of income as well as during an expansion.
a. earning
b. expanses
4. A magic of trading on equity is that trading on equity magnifies-.............
a. loss.
b. Profit
c. none
d. both profit and loss
5. Trading on Equity will lead to a ................... in profitability rate when it
costs more that it earns.
a. Increase
b. decrease
1.7 Let Us Sum Up
After going through this unit we have gained sufficient knowledge on the cost of
funds that we raise for a particular business.
After going through this unit we learnt that concept of cost of funds in finance is
different from that in accounts. Except in case of term loans, it is necessary to take
into consideration market values in case of equity shares, preference shares and
debentures. In case of term loans and debentures there is a tax shelter in respect
of interest payments. For dividend on shares there is no tax shelter. For evaluating
a project it is necessary to know WACC. On the other hand the cost of capital
can be used as a tool to evaluate the financial performance of top management.
There are different sources and costs of capital - Cost of Equity (K ), Cost of
Retained Earnings (Ke), Cost of Preferred Capital (Kp), Cost of Debt (Kd).
E 89
COST OF CAPITAL, There are different approaches to cost of equity - Dividend Method or Dividend
CAPITAL STRUCTURE Price Ratio Method, Dividend Growth Model, Price Earning Yield Model, Capi-
AND LEVERAGES tal Asset Pricing Model. We even studied the various types of cost that are asso-
ciated with the capital and they are Explicit cost and Implicit cost, Historical cost
and Future cost, Average cost and Marginal cost, Specific cost and Composite
cost. One another types of cost known as opportunity cost was also discussed
here it is the cost for gone by choosing one option over an alternative one that may
be equally desired. Thus, opportunity cost is the cost of pursuing one choice in-
stead of another.
After going through this unit the students would have understood in a very interest-
ing way the cost of capital and the various kinds of cost that are associated with
the capital.
Answers: (1-a), (2-a), (3-b), (4-b),(5-a)
Answers: (1-c), (2-b), (3-a), (4-b),(5-a)
Answers: (1-d), (2-b), (3-a), (4-b),(5-a)
Answers: (1-c), (2-a), (3-b), (4-b),(5-a)
Answers: (1-c), (2-a), (3-a), (4-d),(5-b)
1.9 Glossary
1. Optimal Capital Structure - The percentages of debt, preferred stock,
and common equity that will maximize the firm’s stock price.
2. Opportunity Cost -The return on the best alternative use of an asset, or
the highest return that will not be earned if funds are invested in a particular
1.10 Assignment
How is capital structure related to dividend decisionsb Explain.
1.11 Activities
Why is the cost of term loan debentures generally less than cost of equity or
preference capitalb
1.12 Case Study
Read the Annual report of Indian Airlines and study its cost of capital and its
impact on EVA (Economic Value Added) and other areas.
1. Financial Management - Prof. Dr. Mahesh A. Kulkarni.
2. Fundamentals of Financial Management- Dr. Prasanna Chandra.
3. Financial Management - Ravi M. Kishore.
90
Unit CAPITAL STRUCTURE THEORIES
2
: UNIT STRUCTURE :
2.1 Introduction
2.2 Capital Structure
2.2.1 Introduction to Capital Structure
2.2.2 Factors Affecting Capital Structure
2.3 Features of an Optimal Capital Structure
2.4 Capital Structure Theories
2.4.1 Traditional View
2.4.2 Modigliani-Miller Hypothesis
2.5 CAPM and Capital Structure
2.6 Adjusted Present Value
2.7 Let Us Sum Up
2.9 Glossary
2.10 Assignment
2.11 Activities
2.12 Case Study
After learning this unit, you will beable to understand:
 The meaning of Capital Structure.
 List factors affecting the capital structure.
 Theories of capital structure.
 How beta is related to capital structure.
 Explain adjusted present value.
2.1 Introduction
The plan that a company incorporates for its financing is referred to as the capital
structure of the company. In other words, it’s the finances that the company uses
in a long term. As the goal of any company or firm is towards increasing its value
in market, the capital structure of the firm should beplanned or decided in such a
way that it adds to the market value of the firm. Acompany’ s capital structure can
be termed as advantageous if the funds are used in such a manner that it not only
increases the firm’s market value, but also reduces thecompany’ s cost of capital.
2.2 Capital Structure
2.2.1 Introduction to Capital Structure
The capital structure is how a firm finances its overall operations and growth by
91
COST OF CAPITAL, using different sources of funds. Debt comes in the form of bond issues or long-
CAPITAL STRUCTURE term notes payable in the form of loans or debentures while equity is classified as
AND LEVERAGES common stock, preferred stock or retained earnings. Short-term debt such as
working capital requirements is also considered to be part of the capital structure.
A company’s proportion of short and long-term debt is considered when analyz-
ing capital structure. When people refer to capital structure they are most likely
referring to a firm’s debt-to-equity ratio, which provides insight into how risky a
company is. Usually a company more heavily financed by debt having greater risk,
as this firm is relatively highly levered.
2.2.1 Factors Affecting Capital Structure
A company uses fixed fund sources viz debentures, term loans etc. along with
equity capital. This is known as financial leverage. The firms generally make use of
equity to raise debts. The number of debt units a company holds per equity unit is
called the company’s debt equity ratio. It is calculated by a formula
Debt Equity Ratio = Debt / Equity
Ideally, the small scale industries must have debt equity ratio of 3:1 while medium
and large scale industries must have debt equity ratio of 2:1. A ratio of 3:1 indi-
cates that for every 1 equity unit, the company can raise 3 units of debt. Higher the
leverage, higher is the company’s commitments in terms of interests and loan re-
payments. This in turn affects the returns of the equity share holders. Some of the
other factors that must be considered while deciding the firm’s capital structure
are the firm’s size, its cost of capital, trading on equity, cash flow, Flexibility a debt
changes in capital structure, Nature of business, give policies, tax rates etc. the
way the cash flows of the company are projected and other costs incurred.
1. A company uses fixed fund sources viz debentures, term loans etc. along
with equity capital. This is known as .....................
a. Combined leverage
b. Financial leverage
2. Debt Equity Ratio = .....................
a. Debt /Equity
b. Equity /Debt
3. Higher the leverage, higher is the company’s commitments in terms of inter-
ests and loan ....................
a. Payment
b. repayments
2.3 Features of an Optimal Capital Structure
An efficient capital structure should encompass the following features:
 The capital structure should be such that the dilution of control should be
minimal.
 The use of leverage should be optimum and at minimum cost leading to
company’s prosperity.
 The capital structure of the company should enable it to raise need based
funds as well as stop the debts from a particular source if they are too
expensive i.e. the capital structure should beflexible enough to sustain in
varying conditions.
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The use of debts should be minimal as it hampers the company’ s solvency since CAPITAL STRUCTURE
the interest rates are very high. THEORIES
1. The capital structure should be such that the dilution of control should
be...................
a. Maximum
b. Minimal
2. The plan that a company incorporates for its financing is referred to as the
....................... of the company.
a. Equity Share structure
2.4 Capital Structure Theories
The two essential components of capital structure of a company are debt and
equity. Hence, the proportion of debt and equity is very important in capital struc-
ture. In other words, it is very essential to decide the level of financial leverage to
be employed in any company. To decide this, it becomes necessary to understand
the relationship that exists between firms’ cost of capital and its financial leverage.
Some of the assumptions that are made to understand this relationship are
 It is not expected for the net operating income to increase or decrease over
the period of time.
 There is no income tax applicable, neither corporate, nor personal.
 A firm can alter its capital structure at any point of time without even bear-
ing the transaction costs.
 The company can pay its earnings in terms of dividends i.e. the company
can pay 100% dividends.
There are two extreme views on whether there exist any such things as optimal
capital structure.
The Net Income Approach (NI) assumes that the cost of debt and that of equity
are independent to capital structure. With high use of leverage, the weighted aver-
age cost of capital reduces, increasing the value of the firm in totality.
In Net Operating Income (NOI) approach, it is assumed that the cost of equity
increases linearly with leverage. As the leverage changes, the value of the com-
pany and the weighted average cost of capital remains constant.
2.4.1 Traditional View
In Traditional approach, the cost of capital decreases, thereby increasing the value
of the firm. This happens till a particular threshold is reached, after which the
reverse happens i.e. the cost of capital increases thereby causing decline in the
value of the firm.
Traditional approach is the mid-point between the net income and net operating
approach and is often known as an intermediate approach. Traditional view uses
a good mix of debt and equity to increase the firm’s value or decrease its cost of
capital. This approach indicates that the cost of capital reduces within a certain
debt limit and then increases. Hence, according to traditional view, there existsa
thing as optimal capital structure when the cost of capital reduces or the firm’s
market value increases.
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COST OF CAPITAL, In traditional view, the way in which the modifications to the capital structure affect
CAPITAL STRUCTURE the cost of capital can be classified into 3 steps:
AND LEVERAGES  Initially, the cost of equity ke remains unchanged i.e. constant or rises very
little with the debt. And even if it increases, it doesn’t increase so much as to
nullify the effect of a low-cost debt. However, in this stage, the cost of debt
Kd remains constant or increases very slightly. Thus, the value of the firm
increases with decrease in cost of capital and increase in leverage.
 In the second stage, the increase in leverage have minimal or no effect on the
cost of capital or the market value of the firm as, by this time, the firm has
already reached a particular degree of leverage, the reason being, the ad-
vantage of low-cost debt gets counterbalanced due to increase in the cost
of equity. At that specific point, the firm’s value will be at its highest or its
cost of capital will be at its lowest.
 In the last stage, at a certain point, either the value of the firm starts decreas-
ing with leverage or the cost of capital starts increasing. This is because the
investors’ demand for high equity capitalization rate due to high risk involved
counterparts the advantages of low-cost debt.
Thus, these three stages indicate that the cost of capital is dependent on leverage.
It falls with leverage, and reaches a particular minimal point after which it starts
increasing.
The traditional approach is questioned or criticized as it indicates that by changing
the way in which the risk incurred by the security holders is distributed, the totality
of risk incurred by the security holders can be changed.
2.4.2 Modigliani-Miller Hypothesis
Fig 2.1 Optimal Capital Structure

According to Modigliani and Miller, the net operating income approach explains
the relationship between leverage and cost of capital in three propositions. They
have challenged the traditional approach by providing a rational reason for having
constant cost of capital throughout all the levels of leverage.
The propositions made by Modigliani and Miller are based on certain assump-
tions:
 Trading of securities take place in capital markets that are perfect. Also,
there will beno transaction costs involved, i.e. the investors do not have to
bear any costs for buying or selling their securities.
94
 It is assumed that the investors behave rationally by choosing risk and re- CAPITAL STRUCTURE
turn that is most profitable for them. THEORIES
 The probability distribution value is expected to be same for all the inves-
tors.
 The firms can be clubbed together in one class based on their business
risks. Firms that have same level of business risk can come under one
class.
 There is no tax incorporated, neither corporate nor personal.
 There is 100 percentpayout to share holders i.e. the share holders are given
all the net earnings by the firm.
The basic propositions of MM theory are:
Proposition I:
The total of market value of debt and market value of equity i.e. the total market
value of the firm does not depend on the degree of leverage, and is equal to the
firm’s expected operating incomes at the rate pertaining to its risk class.
Thus, as per Proposition I,
Market value of the firm = Market value of equity + Market value of debt
= Expected Net Operating Income / Rate applicable to the firm based on risk
class
Proposition II:
According to the proposition-II, Cost of equity is in a linear (directly propor-
tional) relationship with the Debt-equity ratio. The required return on equity in-
creases as the debt-equity ratio for the firm increases. This means the risk for
equity holder increases with the debt increases in the capital structure.
Proposition III:
The cut-off rate for deciding the investment of a firm belonging to a particular risk
class is not affected by the way in which the firm finances the investment. Thus, as
per the proposition, since the financing and investment decisions are independent
of each other, the financing decisions do not affect the average cost of capital.
Thus, according to the MM theory, the value of the firm is not affected by the
financial leverage. The costs like bankruptcy costs, agencycosts, taxesetc. are
some of the factors that are found to be disadvantageous in this approach.
1. The .................. assumes that the cost of debt and that of equity are inde-
pendent to capital structure.
a. Net Income Approach (NI)
b. Net Operating Income (NOI)
2. According to Modigliani and Miller, the net operating income approach
explains the relationship between ...................... and cost of capital in three
propositions.
a. Cost of fund
b. leverage
3. Traditional approach is the mid-point between the ................ and net op-
erating approach and is often known as an intermediate approach.
a. Net income
b. Net outcome
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COST OF CAPITAL, 2.5 CAPM and Capital Structure
CAPITAL STRUCTURE The shareholder’s return in terms of EPS or ROE is affected by leverage which
AND LEVERAGES also increases financial risk. As a result, the beta of the equity of a firm increases
since it introduces debt in the capital structure of the firm. It is well known that
individual securities form a portfolio and each security has its own beta. Also, the
beta of the portfolio is nothing but the weighted average beta of individual securi-
ties. Likewise, a firm is comprised of portfolio of assets and hence, the weighted
average of betas of individual assets is the betaasset of a firm ba. Thus,
a = 1 w1 + 2 w2 + 3 w3 …
Fig 2.2 CAPM

Where a is weighted average beta of assets, 1 is the beta of asset one, w1 is its
weighted average and so on.
As debt and equity finances a firm’s assets, its asset beta is also the weighted
average of equity beta and debt beta of the firm. Thus,
a = e we + d wd
Where be is equity beta, we is weighted average of equity, d is debt beta and wd
is weighted average of debt.
Debt and equity finances a firm’s assets.
The market value of weighted average of equity is divided by the firm’s total value.
Likewise, the market value of weighted average of debt is divided by the firm’s
total value.
1. The shareholder’s return in terms of EPS or ROE is affected by leverage
which also increases financial ..............
a. Return
b. Risk
2. CAPM and Capital Structure is well known that ................... form a port-
folio and each security has its own beta.
a. Individual securities
b. Mix securities
2.6 Adjusted Present Value
The Adjusted Present Value (APV) is the sum of Net present value (NPV) of a
project if financed exclusively by ownership equity and the present value of all the
benefits of financing. This was first studied by Stewart Myers, a professor at the
MIT Sloan School of Management and then, in 1973, it was theorized by Lorenzo
96
Peccati. The main benefit of this approach is a tax shield resulted from tax de- CAPITAL STRUCTURE
ductibility of interest payments. Another one can be a subsidized borrowing. The THEORIES
APV method of business valuation is normally useful in a Leveraged buy out
(LBO) case since it has tremendous amount of debt, so tax shield is sizeable.
To be precise, an APV valuation model is the standard DCF (Discounted cash
flow model) model. However, cash flows would be discounted at the cost of
assets (instead of WACC), and tax shields at the cost of debt. APV and the
standard DCF gives the same result if the capital structure remains constant.
Formula:
Base-case NPV + Sum of PV of financing
Example:
Initial Investment = 500000
Expected Cash flow = 45000 (Perpetuity)
Opportunity cost of capital : 10%
Tax rate=35%
Project partly financed by 200000
NPV = -500000 + 45000/0.10 = -50000
PV (Tax Shield) = .35 x 200000 = 70000
APV = -50000 + 70000 = 20000
1. The ................ is the sum of Net present value (NPV) of a project if fi-
nanced exclusively by ownership equity and the present value of all the
benefits of financing.
a. DCF
b. Adjusted Present Value (APV)
2. Adjusted Present Value was first studied by Stewart Myers, a professor at
the MIT Sloan School of Management and then, in ................
a. 1975
b. 1973
2.7 Let Us Sum Up
In this unit we discussed the various concepts relating and associated with the
cost and capital structure.
In this unit we discussed the map that a company incorporates for its financing is
referred to as the capital structure of the company. That means it is the finances
that the company uses in the long term. A company’s capital structure would
bebeneficial if the funds are used in a way that it not only increases the firm’s
market value, but also reduces the company’s cost of capital. When a company
uses fixed fund sources like debentures, term loans etc. along with equity capital,
then it is known as financial leverage. An optimal capital structure should be such
that the dilution of control should be minimal; the use of leverage should be high
and at minimum cost leading to company’ s prosperity. The use of debts should
be minimal as it hampers the company’s solvency since the interest rates are very
high. Later in the unit we even discussed the various theories that play a major
role in the determination of capital structure. Here we covered capital structure
theories of Traditional View, Modigliani-Miller Hypothesis; Cost of equity is in a
97
COST OF CAPITAL, linear (directly proportional) relationship with the Debt-equity ratio. The required
CAPITAL STRUCTURE return on equity increases as the debt-equity ratio for the firm increases. We even
AND LEVERAGES discussed the use of beta in capital structure is very important. Adjusted Present
Value (APV) gives the difference between DCF (Discounted Cash Flow) Valua-
tion and APV in using the cost of capital.
So this unit is going to be great help for the readers in understanding the concept
associated with capital structure theories.
Answers: (1-b), (2-a), (3-b)
Answers: (1-b)
Answers: (1-a), (2-b), (3-a)
Answers: (1-b),(2-a)
Answers: (1-c),(2-d)
2.9 Glossary
1. Net Present Value (NPV) Method - A method of ranking investment
proposals using the NPV, which is equal to the present value of future net
cash flows, discounted at the marginal cost of capital.
2. Debenture - A long-term bond that is not secured by a mortgage on spe-
cific property.
2.10 Assignment
Write different Capital structure theories with examples.
2.11 Activities
Which factors affect the Capital Structure of a companyb
2.12 Case Study
Study the Capital Structure of GO Indigo airlines, DLF and Ranbaxy Ltd.
1. Financial management-ICFAI.
2. Financial management – I. M. Pandey
3. Financial management – P. C. Tulsian, Bharat Tulsian
98
Unit ANALYSIS OF LEVARAGES
3
: UNIT STRUCTURE :
3.1 Introduction
3.2 Operating Leverage
3.2.1 Meaning
3.2.2 Formulas
3.2.3 When there can be operating leverage.
3.2.4 What is indicated by operating leverage.
3.2.5 Risk associated with operating leverage.
3.2.6 Component of cost structure which brings higher degree of operat-
ing leverage
3.3 Financial Leverage
3.3.1 Meaning
3.3.2 Formulas
3.3.3 When there can be financial leverage.
3.3.4 What is indicated by financial leverage.
3.3.5 Risk associated with financial leverage.
3.3.6 Component of capital structure which brings higher degree of finan-
cial leverage.
3.4 Total leverage
3.4.1 Meaning
3.4.2 Formulas
3.4.3 What is indicated by total leverage.
3.4.4 Risk associated with total leverage.
3.5 Let us sum up
3.7 Glossary
3.8 Assignment
3.9 Activities
3.10 Case Study
 What is leverage.
 Types of leverages.
 Impact of different leverages on activity of business enterprise
 Computation of different leverages.
99
COST OF CAPITAL, 3.1 Introduction
CAPITAL STRUCTURE The term ‘leverage’ refers to the power to influence results. It represents the im-
AND LEVERAGES pact of introduction of one variable over other related variable. There are two
types of expenses (cost): Fixed Cost and Variable Cost. Variable cost is directly
related with revenue (sales) and it is component of production cost. But fixed are
categorized into two categories (i) Operating Fixed Cost and (ii) Financial Fixed
Cost. On the basis of this classification risks also categorized into two sections (i)
Operating Risk and (ii) Financial Risk. The emergence of operating risk and finan-
cial risk is result of existence of operating and financial leverage respectively. The
size of this risk in business enterprise is measured with the measurement of degree
of operating and financial leverage. Theoretically higher the degree of leverages,
invites higher degree of risk but at the same higher return also. Leverage ratios can
be broadly classified into two groups: (i) Activity leverage and (ii) Structural lever-
age.
Classification of leverages
Activity leverage Structural leverage

Operating Leverage Debit Equity Ratio
Financial Leverage Total Debt to Equity Ratio
Total Leverage Debt to Net worth Ratio
The measurement or computation of activity leverage is based on information of
income statement and structural leverage is based on information of balance sheet.
Explanation of leverages is as follows:
Activity Leverage:-
The term activity refers to day to day activities of the enterprise which are doneto
generate profit. There are three important ratios which are based on income state-
ment. These ratios are (i) Operating Leverage, (ii) Financial Leverage and (iii)
Total Leverage.
To compute activity leverage, the following mentioned income statement will be
useful.
Income Statement
Particulars R
Sales 
Less : Variable Cost 
Contribution 
Less : Operating Fixed Cost 
Earnings Before Interest and Tax (EBIT) 
Less : Interest (Financial Fixed Cost) 
Earnings Before Tax (EBT) 
Less : Tax 
Earnings After Tax (EAT) 
Less : Preference Share Dividend 
Earnings for equity share holders 
÷ No. of Equity Shares 
EPS 
100
3.2 Operating Leverage ANALYSIS OF
3.2.1 Meaning: - LEVARAGES
The emergence or existence of operating leverage is due to operating fixed cost in
cost structure. There are three types of costs for cost structure – variable, fixed
and semi variable or semi fixed. But for computation of operating leverage only
two costs are considered variable and fixed. Operating leverage is evidence of
operating fixed cost in cost structure.
Indication of operating leverage: The degree of operating leverage indicates pro-
portion or percentage change in EBIT due to change in sales.
3.2.2 Formulas:-
Contribution
(i) Degree of operating leverage =
EBIT
(DoL)
Or
% Change in EBIT
Degree operating leverage =
% Change in Sales
3.2.3 When there can be operating leverageb
When Degree of leverage is >1 there can be operating leverage. If DoL = 1, it
indicates there is no operating leverage it means there is no operating fixed cost in
cost structure only variable cost exists.
Illustrations
Firm x and firm y manufacture the same product and their cost sheet is as under:-
Particulars Firm X Firm Y
Sales 6,00,000 6,00,000
Less Variable cost @ 40% 2,40,000 2,40,000
3,60,000 3,60,000
Contribution
1,20,000 1,60,000
Less Operating Fixed Cost
EBIT 2,40,000 2,00,000
Less Interest 60,000 40,000
EBIT 1,80,000 1,60,000
Less Tax 30% 54,000 48,000
EAT 1,26,000 1,12,000
Less Preference shares dividend 30,000 30,000
Earnings for equity share holders 96,000 82,000
÷ No of Equity shares 10,000 10,000
Earnings Per Share (EPS) R 9.60 R 8.20
Ans:-
Firm X
Contribution 3,60,000
DOL = = 1.5
EBIT 2,40,000
The second formula to determine DOL is
101
COST OF CAPITAL, % Change in EBIT
CAPITAL STRUCTURE DOL =
% Change in Sales
AND LEVERAGES
R
Assume Sales of next year is 7,50,000
Less : Variable cost @ 40% 3,50,000
Less : Operating Fixed Cost 1,20,000
EBIT 3,30,000
Here sales is increased by R1,50,000 (R 7,50,000 - R 6,00,000) as compared to
 1,50,000 
previous year and that is 25%   100  while EBIT is increased by b
 6,00,000 
 90,000 
90,000 (b 3,30,000 - b 2,40,000) and that is 37.5%   100 
 4,40,000 
37.5%
 = DOL = 1.5
25%
Note : Under both the formulas DOL would remain same. But for second formula
additional information is needed.
Firm Y
Contribution 3, 00, 000

DOL = = 1.8
EBIT 2, 00, 000
The second formulas to determine DOL is
% Change in EBIT
DOL =
% Change in Sales
R
Assume Sales of next year is 9,00,000
Less : Variable cost @ 40% 3,60,000
Less : Operating Fixed Cost 1,60,000
EBIT 3,80,000
In case of firm Y sales is increased by R 3,00,000 (R 9,00,000 - R 6,00,000) as
 3, 00, 000 
compared to previous year and that is 50%   100  while EBIT is
 6, 00, 000 
increased by R 1,80,000 (R 3,80,000 - R 2,00,000) as compared to previous year
 1,80, 000  90%
and that is 90%  100  R = 1.8
 2, 00, 000  50%
3.2.4 What is indicated by operating leverage.
DOL explains impact of changes in sales on EBIT. In case of firm X and firm Y
DOL is 1.5 and 1.8 respectively. If sales is increased by 1% EBIT of firm X and
102
firm Y would be increase by 1.5% and 1.8% respectively. If sales increase by 5% ANALYSIS OF
in this case EBIT of Firm X and firm Y would increase by 7.5% (1.5% x 5%) and LEVARAGES
9% (1.8% x 5%) respectively.
Let us confirm this impact
Sales (old) 6,00,000 6,00,000
Add: 5% increase 30,000 30,000
New Sales 6,30,000 6,30,000

Less: Variable Cost @ 40% 2,52,000 2,52,000
Contribution 3,78,000 3,78,000
Less: Fixed Cost 1,20,000 1,60,000
EBIT (New) 2,58,000 2,18,000

Less: EBIT (Old) 2,40,000 2,00,000
 18,000   18,000 
Increase in EBIT  100   100 
Increase in EBIT in Percentage  2, 40, 000   2,00,000 
7.5% 9%
3.2.5 Risk is associated with operating leverage.
Operating risk is associated with operating leverage. There is positive relation
between operating leverage and operating risk. Operating risk is based on size of
operating leverage. Higher the degree of operating leverage higher the degree of
operating risk. Operating risk is known as Business Risk also.
But at the same time risk and return also have positive relation. Higher the risk,
higher the return.
3.2.6 Component of cost structure which brings higher degree of operat-
ing leverage.
Higher operating fixed cost is responsible for higher degree of operating leverage.
Explanation:-
In the illustration, information about two firms is given. Both the firms have uni-
form sales, variable cost and contribution but their operating fixed cost is differ-
ent.
Due to different fixed costs (firm X R 1,20,000 and firm Y R 1,60,000) so DOL is
also different i.e. 1.5 and 1.8 for firm X and firm Y respectively.
Here firm Y is more riskier than firm X because DOL of firm Y is 1.8 and Firm X
is 1.5.
But at the same due to higher risk the return of firm Y will be higher than firm X,
when sales would increase EBIT of firm Y would increase by 7.5% and of firm X
would increase by 9% when sales is increase by 5%.
Check Your Progress – 1
1) Operating leverage is categorized as ________________
(a) Activity Leverage
(b) Structural Leverage
2) Operating leverage is associated with ______________
(a) Capital Structure
(b) Cost Structure
103
COST OF CAPITAL, 3) The degree of operating leverage indicates proportion or percentage change
CAPITAL STRUCTURE in __________ due to change in __________
AND LEVERAGES (a) Sales, EBIT
(b) EBIT, Sales
4) When operating leverage is 1% means
(a) No Variable Cost in Cost Structure
(b) No Fixed Cost in Cost Structure
5) Formula to determine degree of operating leverage is
EBIT
(a)
Contribution
Contribution
(b)
EBIT
3.3 Financial Leverage
3.3.1 Meaning :
The emergence of existence of Financial Leverage is due to Financial Cost (inter-
est) in the Capital Structure. When along with owners capital, borrowed capital is
used it shows existence of Financial Leverage in the capital structure. Investors
are paid either interest or/and Dividend. The payment of dividend does not create
financial leverage. Only interest which is tax deductible creates existence of Finan-
cial Leverage.
The use of borrowed capital in the Capital Structure is used of Financial Lever-
age. Financial Leverage is known as “Trading on Equity” also.
Indication of Financial Leverage – The degree of Financial Leverage indicates
proportion or percentage change in EPS due to change in EBIT.
3.3.2 Formulas
EBIT
(i) Degree of Financial Leverage =
EBT
(DFL)
To calculate pre tax and preference dividend DFL the above stated Formula is
used.
OR
 2 .8 0 
(ii) Degree of Financial Leverage =  100 
 8 .2 0 
EBIT
(iii) DFL =
Dp
EBIT  I 
(1  1)
To calculate post interest tax and preference dividend DFL the above stated for-
mula is used.
104
3.3.3 When there can be Financial Leverageb ANALYSIS OF
When degree of Financial Leverage is >1, there can be Financial Leverage. If LEVARAGES
DFL = 1, it indicates there is not Financial Leverage, it means there is no interest
cost (borrowed capital) in capital structure, only owners funds exist.
From the given illustration Financial Leverage will be calculated as follows:
Firm X :
Pre Tax and preference dividend DFL will be calculated
EBIT 2, 40, 000

DFL = = 1.33
EBT 1,80, 000
The application of second formula is based on following formula. Post interest,
Tax and preference dividend DFL will be calculated as follows:
EBIT 2, 40, 000

DFL = =
Dp 30, 000
EBIT  I  2, 40,000 
(1  1) (1  0.30)
2, 40, 000 2, 40, 000

= = = 1.75
2, 40, 000  1, 02,857 1,37,143
R
Assume EBIT of next year is 2,64,000
Less : Interest 60,000
EBIT 2,04,000
Less : Tax 30% 61,200
EAT 1,42,800
30,000
Less: Preference Share Dividend
Earning for Equity share holders 1,12,800
÷ No. of Equity shares 10,000
EPS 11.28
Increase in EBIT & EPS
EBIT EPS
NEW 2,64,000 11.28
2, 40, 000 9.60
OLD
2, 40, 000 1.68
In % 10% 17.5%
17.5%
DFL = = 1.75
10%
Note: - Under both the formulas DFL would remain same. But for use of Second
formula, additional information is required.
Firm Y:-
Pre tax and preference dividend DFL will be calculated as follows:-
105
COST OF CAPITAL, EBIT 2, 00, 000
CAPITAL STRUCTURE DFL = = 1.25
EBT 1, 60, 000
AND LEVERAGES
% Change in EPS
The second formula to determine DFL is
% Change in EBIT
The application of second formula is based on following formula.
Post Interest, Tax and Preference dividend DFL will be calculated as follows:
EBIT 2,00,0000
DFL = PD 30,000
EBIT - I - 2,00,000 - 40,000 -
(1- t) (1-1.30)
2,00,0000 2,00,0000
= = = 1.71
2,00,000 - 82,857 1,17,143
R
Assume EBIT of next year is 2,30,000
Less : Interest 40,000
EBIT 1,90,000
Less : Tax 30% 57,000
1,33,000
EAT 30,000
Less: Preference Share Dividen d
Earning for Equity share holders 1,03,000
÷ No. of Equity shares 10,000
= EPS 10.30
Increase in EBIT and EPS
EBIT EPS
NEW 2,30,000 10.30
2,00,000 8.20
OLD
30,000 2.10
In % 15% 25.61%
25.61%
DFL = = 1.71
15%
3.3.4 What is indicated by Financial Leverage.
DFL explains impact of changes in EBIT on EPS. In case of firm X and firm Y
DFL is 1.75 and 1.71 respectively. If EBIT is increased by 1% EPS of firm X and
firm Y would increase by 1.75% and 1.71% respectively. If EBIT is increase by
20% in this case EPS of firm X and firm Y would be increase by 35% (1.75% x
20%) and 34.2% (1.71 x 20%) respectively.
106
Let us confirm this impact ANALYSIS OF
Particulars Firm X Firm Y LEVARAGES
EBIT (OLD) 2,40,000 2,00,000
Add: 20% increase 48,000 40,000
NEW EBIT 2,88,000 2,40,000
Less: Interest 60,000 40,000
EBT 2,28,000 2,00,000
Less: Tax 30% 68,400 60,000
EAT 1,59,600 1,40,000
Less: Preference Share Dividend 30,000 30,000
Earnings for Equity Share Holders
÷ No. of Equity Shares 1,29,600 1,10,000
10,000 10,000
NEW EPS
12.96 11.00
- OLD EPS
9.60 8.20
Increase in EPS
 3.36   2.80 
 9.60 100   8.20 100 
   
35% 34.14%
3.3.5 Risk is associated with Financial Leverage.

Financial risk is associated with Financial Leverage. There is positive relation
between Financial Leverage and Financial risk. Financial risk is based on size of
Financial Leverage and size of Financial Leverage is based on size interest to be
paid for borrowed capital. Higher the amount of interest, higher the degree of
Financial Leverage and consequently higher the financial risk.
But at the same time risk and return also have positive relation. Higher the risk,
higher the return.
3.3.6 Component of capital structure which brings higher degree of Fi-
nancial Leverage.
Higher interest cost (which is known as fixed financial cost) is responsible for
higher degree of financial leverage.
Explanation :
In illustration, information about two firms is given. Both firms have uniform sales,
variable cost, contribution but their interest cost is different.
Due to different interest cost (firm X b 60,000 and firm Y b 40,000), So DFL is
also different i.e. 1.75 and 1.71 for firm X and firm Y respectively.
Here firm X is more riskier than firm Y, because DFL of firm X is higher than firm
Y and i.e. 1.75 and 1.71 respectively.
But at the same time due to higher risk the return of firm X will be higher than firm
Y. Here when EBIT is increased by 20%, EPS of firm X is increased by 35% and
of form Y is increased by 34.14%.
1) Financial Leverage is determined with the help of ________
(a) Interest
(b) Operating fixed cost
2) Financial Leverage is associated with __________
(a) Capital structure
(b) Cost structure
107
COST OF CAPITAL, 3) ___________is component of financial leverage.
CAPITAL STRUCTURE (a) Interest
AND LEVERAGES (b) Dividend
4) Financial Leverage explains the changes in _______on changes in ______
(a) EBIT, EPS
(b) EPS, EBIT
5) Preference Share dividend applied in computation of _______
(a) Operating Leverage
(b) Financial Leverage
3.4 Total Leverage
3.4.1 Meaning:-
Total Leverage is multiplication of operating leverage and financial leverage. Total
leverage explains total risk i.e. operating and financial risk.
Indication of Leverage: The degree of total leverage indicates proportion or per-
centage change in EPS due to change in sales.
3.4.2 Formulas
(i) Degree of Total Leverage = DOL × DFL
(DTL)
Contribution
(ii) DTL =
 ( Dp ) 
Contribution  OF  I  
 1  t 
Where contribution = Sales value – Total variable cost
OF = Operating Fixed Cost
I = Interest
Dp = Preference share dividend
E = Income tax rate
DTL = DOL × DFL
Firm X Firm Y
1.5 1.8
x 1.75 x 1.71
2.625 3.078
OR
Contribution
DTL =
 ( Dp ) 
Contribution  OF  I  
 1  t 
108
Firm X Firm Y ANALYSIS OF
3,60,000 3, 60, 000 LEVARAGES
 30, 000   30,000 
3,60,000  1, 20,000  60,000   3, 60,000 1,20,000  60,000  
 1  .30   1  .30 
3, 60, 000 3,60,000
3,60,000  2,22,857 3, 60,000  2,42,857
3,60,000 3, 60, 000
1,37,143 1,17,143
2.625 3.078
3.4.3 What is included by Total Leverage.

DTL explains impact of changes in sales on EPS. In case of firm X and firm Y
DTL: is 2.625 and 3.078 respectively. If sales is increased by 1% EPS of firm X
and firm Y would increase by 2.625% and 3.078% respectively. If sales is in-
creased by 10% in this case EPS of firm x and firm Y would increase by 26.25%
(2.625% x 10%) and 30.78% (3.078% x 10%) respectively.
Let us confirm this impact
Sales 6,00,000 6,00,000
Add: 10% increase 60,000 60,000
NEW sales 6,60,000 6,60,000

2,64,000 2,64,000
Less: Variable Cost
3,96,000 3,96,000
Contribution 1,20,000 1,60,000
Less: Operating Fixed Cost
2,76,000 2,36,000
EBIT 60,000 40,000
Less: Interest
2,16,000 1,96,000
EBT
Less: Tax 30% 64,800 58,800
EAT 1,51,200 1,37,200
Less: Preference Dividend 30,000 30,000
Earning for Equity share holders 1,21,200 1,07,200
÷ No of Equity Shares 10,000 10,000
NEW EPS 12.12 10.72
Less: OLD EPS 9.60 8.20
Increase in EPS  2.52   2.52 
  100    100 
 9.60   8.20 
Increase in EPs in % 26.25 30.7
109
COST OF CAPITAL, 3.4.4 Risk is associated with Total Leverage.
CAPITAL STRUCTURE Total risk is associated with total leverage. There is positive relation between Total
AND LEVERAGES Leverage and total risk. Total risk is based on size of Operating and Financial
Leverage. Higher the size of Total Leverage, higher the total risk.
But at the same time risk and return also have positive relation. Higher the risk
higher the return.
Explanation:-
In the illustration, information about two firms is given. Both the firms have uniform
sales, variable cost and contribution. But their operating fixed and interest – costs
are different.
Due to different operating fixed cost and interest cost, their DTL are different.
Here firm Y is more riskier than firm X, because DTL of firm Y is 3.078 and of X
firm is 2.625. But at the same due to 10% increase in sales EPS of X firm is
increased to 26.25%. While that of Y firm is increased to 30.78%. So due to
higher risk Y received higher return.
(1) Total Leverage is _____________of operating leverage and Financial Le-
verage.
(a) Multiplication
(b) Addition
(2) Total Leverage gives ____________
(a) Financial Risk
(b) Total Risk
(3) There is ____________relation between total leverage and total risk
(a) Negative
(b) Positive
3.5 Let us Sum up
In this unit we studied meaning of different leverages and their impact.
The role of leverage is to accelerate the return for investors, if factors are found to
be favourable. Three types of leverages are covered in this unit namely Operating
Leverage, Financial Leverage and Total Leverage. The specific risk is associated
with each leverage. Operating risk is associated with operating leverage. Financial
risk is associated with financial leverage while total risk is associated with total
leverage.
We studied the impact of each leverage on return. Any change in sales is reflected
in EBIT and this reflection is explained by operating leverage. Any change in EBIT
is reflected in EPS and this reflection is explained by financial leverage while any
change in sales is reflected in EPS and this reflection is explained by total leverage.
The concept of risk and return is also studied in the context of leverage. High
degree of all leverages always brings high risk but at the same time high return
also.
After having proper reading of this unit reader must be able to understand concept
of all types of activity leverage and risk associated with them.
110
3.6 Answers for check your progress ANALYSIS OF
Check Your Progress – 1 LEVARAGES
Answers: - (1-a) (2-b) (3-a) (4-a) (5-b)
Answers: - (1-a) (2-a) (3-a) (4-a) (5-b)
Answers: - (1-a) (2-b) (3-b)
3.7 Glossary
1. Operating risk : Operating risk is known as business risk. It arises due to
fixed overhead in cost structure.
2. Financial Risk : It arises due to change of interest in use of borrowed
capital
3. Trading on Equity: it is synonyms of financial leverage. When debt com-
ponent is used in the capital structure to enhance the return to equity share
holders is called trading on equity.
3.8 Assignment
State different leverages which are used to accelerate the return of investors.
3.9 Activities
Differentiate between operating leverage and financial leverage.
3.10 Case Study
Obtain annual report of any two companies listed on Bombay Stock Exchange,
calculate their financial leverage and undertake comparison of calculated financial
leverage.
1. Financial Management – Ravi M Kishore
2. Financial Management – I.M. Pandey
111
COST OF CAPITAL, BLOCK SUMMARY
CAPITAL STRUCTURE After reading this the readers would have got the sufficient idea about hte capital
AND LEVERAGES and various concepts that are associated with capital and its structure. The follow-
ing topics were studied in this block.
The first unit of the block covered the topic cost of capital in detail. It also ex-
plained the readers about the various elements of cost of capital. Discussion was
also be made on opportunity cost. The writer tried his best to explain the topics in
most easy language and even kept the content of the book concise but under-
standable. Here he made a detailed study on the various factors that affects the
capital structure i.e whether the capital should contain equity or debt or in what
ratio the equity and debtbe maintained. Later in the unit various theories of capital
structure shall also be discussed in detail. These capital structure theories are con-
sidered to be very important in understanding the various concepts of capital and
its cost. To accelarate the refum of the firm leverage plays vital role. In unit 3
analysis of leverages is undertaken. Three types of leverages - operating, financial
and combined leverages are explained.
After going through this block the students would have got the sufficient exposure
to various concepts associated with capital structure and its theories.
112
Block Assignment

a. Cost of equity capital.
b. Difference between book value rate and Market value rate.
c. Opportunity cost of capital.
d. Traditional View.
e. Three approaches of M-M.
f. Debt-equity ratio’ s importance in capital structure.
g. Risk associated with leverage.

1. Discuss the Modigliani miller approach in detail.
2. What do you understand by optimal capital structure.
3. Explain different leverages with illustrations.
113
COST OF CAPITAL, Enrolment No.
CAPITAL STRUCTURE 1. How many hours did you need for studying the unitsb
AND LEVERAGES
Unit No 1 2 3
Nos. of Hrs
2.
Please give your reactions to the following items based on your reading of the
block:
………………………………………………………………………………………
………………………………………………………………………………………
………………………………………………………………………………………
………………………………………………………………………………………
………………………………………………………………………………………
………………………………………………………………………………………
………………………………………………………………………………………
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114
Ambedkar
OpenUniversity
BLOCK-3 WORKING CAPITAL MANAGEMENT AND

INVESTMENT
UNIT 1
WORKING CAPITAL MANAGEMENT-I
UNIT 2
WORKING CAPITAL MANAGEMENT-II
UNIT 3
INVESTMENTS AND FUND
WORKING CAPITAL BLOCK 3: WORKING CAPITAL MANAGEMENT AND
MANAGEMENT AND INVESTMENT
INVESTMENT Block Introduction
Finance, as already discussed is one of the most important parts of any business
unit, without which none of the business can survive. The capital required may
be of several types. The capital required may be of short term need or for long
term need. The capital required for short term is required for the day to day
running of business where as capital for long term is required for the acquisition
of long term assets. Capital for short duration is required for the purpose of
meeting current liabilities against creditors for stock, salary to employees etc.
The capital for short duration is known as working capital and has been dis-
cussed here in verydetail.
In this block the whole content was divided into four units Unit 1 and 2 talks
about the working capital. These units have discussed in detail about working
capital. It discusses about Meaning and Definition of Working Capital, Types of
Working Capital, Factors Affecting Working Capital / Determinants of Working
Capital, Operating Working Capital Cycle, Working Capital Requirements, Esti-
mating Working Capital Needs and Financing Current Assets. On the other hand
unit 2 discusses about in detail about Inventory Management, Purpose of holding
inventories, Types of Inventories, Inventory Management Techniques, Pricing of
inventories, Receivables Management, Purpose of receivables, Cost of main-
taining receivables, Monitoring Receivable, Cash Management, Reasons for
holding cash, Factors for efficient cash management. In the unit 3rd discussed
about the capital budgeting and its importance in a organisation it discusses about
Capital Budgeting, Principles of Capital Budgeting, Kinds of Capital Budgeting
Proposals, Kinds of Capital Budgeting Decisions, Capital Budgeting Techniques,
Estimation of Cash flow for new Projects, Sources of long Term Funds.
This unit is going to be of great help for the readers in understanding the con-
cepts relating to working capital.
Block Objective
After learning this block, you will be able to understand:
 Working Capital Cycle.
 Factors Which Influence Working Capital Need In Organisation.
 Inventory Management.
 Receivables Management.
 Cash ManagementTechniques.
 Inventory
 Various Techniques of Inventory Management.
 Capital budgeting.
 Cash Flow And Accounting Profit
 NPV And The Internal Rate Of Return(IRR)
Block Structure
Unit-1: Working Capital Management-I
Unit-2: Working Capital Management-II
Unit-3: Investments and Fund
116
Unit
WORKING CAPITAL MANAGEMENT - I
1
: UNIT STRUCTURE :
1.1 Introduction
1.2 Meaning and Definition of Working Capital
1.3 Types of Working Capital
1.4 Factors Determining Working Capital
1.5 Operating Working Capital Cycle
1.6 Working Capital Requirements
1.7 Estimating Working Capital Needs and Financing Current Assets
1.8 Strategies in working capital management
1.9 Estimation of working capital.
1.10 Let Us Sum Up
1.12 Glossary
1.13 Assignment
1.14 Activities
1.15 Case Study
 How working capital cycle operates?
 Factors which influence working capital requirements.
 Calculate average working capital requirements.
 Enumerate components of capital structure.
 Measure business risk, financial risk and total risk through leverage.
1.1 Introduction
Working capital is significant in financial management due to the fact that it
plays an important role in keeping the wheels of a business enterprise run-
ning. It may be regarded as lifeblood of a business. It is concerned with short
term financial decisions. Its effective provision can do much to ensure the
success of a business, while its inefficient management can lead not only to
loss of profits but also to the ultimate downfall of promising concept. A
study of working capital is of major importance to internal and external analysis
because of its close relationship with day-to-day operations of a business.
117
WORKING CAPITAL Working capital management includes management of various components
MANAGEMENT AND of current assets as well as current liabilities.
INVESTMENT A firm invests a part of its permanent capital in fixed assets and keeps a part
of it for working capital i.e. for meeting the day to day requirements. The
requirements of working capital varies from firm to firm depending upon the
nature of business, production policy, market conditions, seasonality of op-
erations, conditions of supply etc. Working capital management if carried out
effectively, efficiently and consistently will assure the health of an organiza-
tion.
1.2 Meaning and Definition of Working Capital
In accounting, W. C. is the difference between the inflow and outflow of
funds. It is the net cash inflow.
W.C. is defined as the excess of current assets over its current liabilities and
provision. Current assets are those assets which will be converted into cash
with the current account period or within the next year as a result of the
ordinary operations of the business.
Efficient working capital management requires that the firms should operate
with some amount of Net working capital (NWC), the exact amount varying
from firm to firm and depending, among other things, on the nature of indus-
try. The greater the margin by which the current assets cover the short term
obligations, the more able it will be to pay its obligations when they become
due for payment.
1. ___________is defined as the excess of current assets over its current
liabilities and provision.
a. Profit
b. Net profit
2. In accounting, __________ is the difference between the inflow and
outflow of funds. It is the net cash inflow.
a. W. C.
b. C.W
1.3 Types of Working Capital
Net Working C pit l
Gross Working C pit l C sh Working C pit l
Perm nent Working C pit l
V ri le Working C pit l Neg tive Working C pit l
B l nce Sheet Working C pit l
Fig 1.1 Type of Capital
118
Types of Working Capital
WORKING CAPITAL
1. Networking Capital MANAGEMENT - I
Networking Capital is the difference between current assets and cur-
rent liabilities. The concept of net working capital enables a firm to
determine how much amount is left for operational requirements.
2. Gross Working Capital
Gross working capital is the amount of funds invested in the various
components
 Financial Managers are profoundly concerned with current assets:
 Gross working Capital provides the current amount of working capital
at the right time;
 It enables a firm to realize the greatest return on its investment;
 It helps in the fixation of various areas of financial responsibility;
 It enables a firm to plan and control funds and to maximize the return
on investment.
For these advantages, gross working capital has become a more ac-
ceptable concept in financial management.
3. Permanent Working Capital
Permanent Working Capital is the minimum amount of current assets
which is needed to conduct a business even during the dullest season of
the year. This amount varies from year to year, depending upon the
growth of a company and the stage of the business cycle in which it
operates. It is the amount of funds required to produce the goods and
services which are necessary to satisfy demand at a particular point. It
represents the current assets which are required on a continuing basis
over the entire year. It is maintained as the medium to carry on opera-
tions at any time. Permanent working capital has the following charac-
teristics:
 It is classified on the basis of the time factors;
 It constantly charges from one asset to another and continues to re-
main in the business process
 Its size increase with the growth of business operations
4. Temporary or Variable Working Capital
It represents the additional assets which are required at different times
during the operating year-additional inventory, extra cash, etc. Sea-
sonal working capital is the additional amount of current assets- par-
ticularly cash, receivable and inventory which is required during the
more active business seasons of the year. It is temporarily invested in
current assets and possesses the following characteristics;
 It is not always gainfully employed, though it may change from one
asset to another, as permanent working capital does;
 It is particularly suited to business of a seasonal or cyclical nature.
119
WORKING CAPITAL 5. Balance sheet working capital
MANAGEMENT AND The balance sheet working capital is not which is calculated from the
INVESTMENT items appearing in the balance sheet. Gross working capital which is
represented by the excess of current assets, and net working capital
which is represented by the excess of current assets over current liabili-
ties are examples of the balance sheet working capital.
6. Cash working capital
Cash working capital is one which is calculated from the items appear-
ing in the profit and loss accounts of current assets. This concept has
the following advantages -
It shows the real flow of money or value at a particular time and is
concerned to be the most realistic approach in working capital manage-
ment. It is the basis of the operation cycle concept which has assumed a
great importance in financial management in recent years. The reason is
that the cash working capital indicates the adequacy of the cash flow
which is an essential pre - requisite of a business.
7. Negative working Capital
Negative working Capital emerges when current liabilities exceed cur-
rent assets. Such a situation is not absolutely theoretical and occurs
when a firm is nearing a crisis of some magnitude.
1. _____________working capital is the amount of funds invested in the
various components.
a. Net
b. Gross
2. ____________is the difference between current assets and current li-
abilities.
a. Marketing Capital
b. Networking Capital
3. _____________is maintained as the medium to carry on operations at
any time
a. Permanent Working Capital
b. Working Capital
120
1.4 Factors Determining Working Capital WORKING CAPITAL
MANAGEMENT - I
Fig 1.2 Factors Affecting Working Capital

Railroad, with their large fixed investments, appear to have the lowest re-
quirements for current assets. This does not mean that the problems of working
capital may be minimized in this field of enterprise, since ready funds are still
essential to cover disbursement for wages, interest on funded debt, purchase
of materials and supplies, etc. Indeed, under such conditions the working
capital position may become even more strategic in character because of its
relation to, and control of, the large amount of fixed assets. Thus, one of the
outstanding problems of railroad management in recent years has been the
maintenance of a current position sufficiently strong to permit vigorous op-
erations. Public utilities like rail roads have large fixed investments which
cause the current assets to constitute only arelatively small percentage of the
total assets. There is a difference between operating and holding companies,
but even then the funds to cover current transactions are minor as compared
with those necessary to finance the long term structure.
Industrial concerns, generally, require a large amount of working capital,
although it varies from business to business with lack of uniformity
characterising each field of enterprise. However, the underlying determinants
of the amount are essentially the same as in the earlier groups. Where large
amounts of fixed capital are required for operation, working assets May be
expected to occupy asmaller niche in the asset structure. For similar reasons,
121
WORKING CAPITAL a rapid turnover of capital (sales divided by total assets) will inevitably means
MANAGEMENT AND a large proportion of current assets in the case of industries with large fixed
INVESTMENT investment. One of the primary uses of working capital is its conversion into
operation which will normally replace such defections. This means that the
flow of a portion of the working capitals circulated through fixed investment
and that its recovery is dependent upon the income realized. Where the cur-
rent assets are relatively more important, a rapid sales turnover is usually
found. Often, as in the case of retail concerns, the specific working assets
constitute the object of sale and recovery is direct and immediate. In manu-
facturing enterprises, a large share of working capital is more likely to get
converted into finished products; but even here, the potentiality of recovery
is not delayed as much as in the case of public utilities and railroads. The need
for working capital varies with changes in the volume of business. A consid-
erable proportion of current assets are needed permanently as fixed assets. At
the same time, new receivable accumulate and old ones are converted into
cash. Cash is utilized in the production process. The following factors deter-
mine the amount of working capital;
Nature of Industry: The composition of an asset is a function of the size of
a business and the industry to which it belongs. Small companies have smaller
proportions of cash, receivables and inventory than large corporations. This
difference becomes more marked in large corporations. A public utility, for
example, mostly employs fixed assets in its operations, while merchandising
department depends generally on inventory and receivables. Needs for work-
ing capital are thus determined by the nature of an enterprise.
Demand of Industry: Creditors are interested in the security of loans. They
want their obligations to be sufficiently covered. They want the amount of
security in assets which are greater than the liability.
Cash Requirements: Cash is one of the current assets which is essential for
successful operations of the production cycle. Cash should be adequate and
properly utilised. It would be wasteful to hold excessive cash. A minimum
level of cash is always required to maintain good credit good credit relations.
Richards Osborn has pointed out that cash has a universal liquidity and ac-
ceptability. Unlike illiquid assets, its value is clear-cut and definite.
Nature of Business: The nature of business is an important determinant of
the level of the working capital. Working capital requirements depend upon
the general nature or type of business. They are relatively low in public utility
concerns, in which inventories and receivables are rapidly converted into cash.
Manufacturing organizations, however, face problems of slow turnover of
inventories and receivables, and invest large amount in working capital.
Time: The level of working capital depends upon the time required to manu-
facture goods. If the time is longer, the size of working capital is greater.
Moreover, the amount of working capital depends upon inventory turnover
and the unit cost of the goods that are sold. The greater this cost, the bigger
is the amount of working capital.
Volume of Sales: This is the most important factor affecting the size and
122
components of working capital. A firm maintains current assets because they
WORKING CAPITAL
are needed to support the operational activities which result in sales. The
MANAGEMENT - I
volume of sales and size of the working capital are directly related to each
other. As the volume of sales increases, there is an increase in the investment
of working capital in the cost of operations, in inventories and in receivables.
Terms of purchase and Sales: If the credit terms of purchase are more
favourable and those of sales less liberal, less cash will be invested in inven-
tory. With more favourable credit terms, working capital requirements can
be reduced. A firm gets more time for payment to creditors or suppliers. A
firm which enjoys greater credit with banks needs less working capital.
Inventory Turnover: If the inventory turnover is high, the working capital
requirements will be low. With abetter inventory control, a firm is able to
reduce its working capital requirements. While attempting this, it should de-
termine the minimum level of stock which it will have to maintain through-
out the period of its operations.
Receivable Turnover: It is necessary to have an effective control of receiv-
ables. A prompt collection of receivables and good facilities for settling
payables result into low working capital requirements.
Business Turnover: The business turnover of the organization directly calls
for systematic planning for production. The exploitation of the available busi-
ness can be achieved only when sufficient raw materials are stored and sup-
plied. Hence Business Turnover willalso influence the working capital.
Business Cycle: Business expands during periods of prosperity and declines
during the period of depression. Consequently, more working capital is re-
quired during periods of prosperity and less during the periods of depres-
sion. During marked upswings of activity, there is usually a need for larger
amounts of capital to cover the lag between collection and increased sales
and to finance purchases of additional materials to support growing business
activity. Moreover, during the recovery and prosperity phase of the business
cycle, prices of raw materials and wages tend to rise, requiring additional
funds to carry even the same physical volume of business. In the downswing
of the cycle, there may be abrief period when collection difficulties and de-
clining sales together cause embarrassment by requiring replenishing of cash.
Later, as the depression runs its course, the concern may find that it has a
larger amount of working capital on hand than current business volume may
justify.
Volume of Current Assets: A decrease in the real value of current assets as
compared to their book value reduces the size of the working capital. If the
real value of current assets increases, there is an increase in working capital.
Variation of Sales: A seasonal business requires the maximum amount of
working capital for a relatively short period of time.
Production Cycle: The time taken to convert raw materials into finished
products is referred to as the production cycle or operating cycle. The longer
the production cycle, the greater is the requirement of working capital. An
utmost care should be taken to shorten the period of the production cycle in
order to minimize working capital requirements.
123
WORKING CAPITAL Credit Controls: Credit Controls includes such factors as the volume of
MANAGEMENT AND credit sales, the terms of credit sales, the collection policy, etc. With a sound
INVESTMENT credit control policy, it is possible for a firm to improve its cash inflow.
Liquidity and Profitability: If a firm desires to take a greater risk for bigger
gains or losses, it reduces the size of its working capital in relation to its sales.
If it is interested in improving its liquidity, it increases the level of its working
capital. However, this policy is likely to result in a reduction of the sale vol-
ume, and, therefore, of profitability. A firm, therefore, should choose between
liquidity and profitability and decide about its working capital requirements
accordingly.
Inflation: As a result of inflation, size of the working capital is increased in
order to make it easier for a firm to achieve abetter cash inflow. To some
extent, this factor may be compensated by the rise in selling price during
inflation.
Seasonal Fluctuations: Seasonal Fluctuations in sales affect the level of vari-
able working capital. Often, the demand for product may be of a seasonal
nature. Yet inventories have got to be purchased during certain season only.
The size of the working capital in one period may, therefore, be bigger than
that in another.
Profit Planning and Control: The level of working capital is decided by the
management in accordance with its policy of profit planning and control.
Adequate profit assists in the generation of cash. It makes it possible for the
management to plough back a part of its earnings in the business and substan-
tially build up internal financial resources.A firm has to plan for taxation pay-
ments, which are an important part of working capital management. Often
dividend policy of a corporation may depend upon the amount of cash avail-
able to it.
Repayable Ability: A firm’s repayment ability determines level of its work-
ing capital. The usual practice of a firm is to prepare cash flow projections
according to its plans of repayment and to fix working capital levels accord-
ingly.
Cash Reserves: It would be necessary for a firm to maintain some cash re-
serves to enable it to meet contingent disbursements. This would provide
abuffer against shortages in cash flows.
Operational and Financial Efficiency: Working capital turnover is improved
with abetter operational and financial efficiency of a firm. With a greater
working capital turnover, it may be able to reduce its working capital require-
ments.
Changes in Technology: Technology developments related to the produc-
tion-process have a sharp impact on the need for working capital.
Firms Policies: These affect the level of permanent and variable working
capital.Changes in credit policy, production policy, etc., are bound to affect
the size of working capital.
Size of the Firm: A firm’s size, either in terms of its assets or sales, affects its
124
need for working capital. Bigger firms, with many sources of funds, may
WORKING CAPITAL
need less working capital as compared to their total assets or sales.
MANAGEMENT - I
Activities of the Firm: A firm’s stocking on heavy inventory or selling on
easy credit terms calls for a higher level of working capital for it than for
selling services or making cash sales.
Attitude of Risk: The greater the amount of working capital, the lower is
the risk of liquidity.
Whenever there is current strain, it has to be immediately diagnosed on the
basis of the red signals which manifest themselves in the operation. The cause
should be ascertained by making thorough study of the components of cur-
rent assets and current liabilities.
If stock is not moving fast, and if there is an excess inventory build-up, cor-
rective steps should be taken to sell the stock or bring down its level. If the
receivables have become sticky, effective recovery steps should be taken to
reduce the debts and to increase the collections. Sometimes short-term funds
have been used to finance fixed assets, and this creates the current strain.
This imbalance in the pattern of financing should be set right by raising long-
term funds on the cover of fixed assets so that the current strain may be
wiped out. Similarly, if current funds are diverted outside when they are
badly required within the firm itself, it would be very difficult to run the
business. External diversion may be for the purpose of outside investment,
advance to other or allied concerns or may be in the form of drawing from
the business or for various other purposes. The situation can improve only if
this external diversion is stopped. If the strain is allowed to continue business
of involvement in any other business or industry, the consequences may be
disastrous. In such a situation, the ability to meet current demands deterio-
rates; short-term credits are not forthcoming; production is affected; sales
decline; cash flow dwindles; income may disappear; and the whole enterprise
may get into the red over a period of time.
1. The composition of an________is a function of the size of a business
and the industry to which it belongs.
a. Equity
b. Asset
2. ____________related to the production-process have a sharp impact
on the need for working capital.
a. Technology developments
b. Management Development
14
1.5 Operating Working Capital Cycle
A new concept which is gaining more importance in recent years is the ?Op-
erating Cycle concept‘ of Working Capital. The operating cycle refers to the
average time elapses between the acquisition of raw materials and the final
125
WORKING CAPITAL cash realization. Then the raw materials and stores are issued to the produc-
MANAGEMENT AND tion department. Wages are paid and other expenses are incurred in the pro-
INVESTMENT cess and work-in-process comes into existence. Work-in-process becomes
finished goods. Finished goods are sold to customers on credit. In the course
of time, these customers pay cash for the goods purchased by them. ?Cash‘ is
retrieved and the cycle is completed. Thus, operating cycle consists of four
stages:
 The raw materials and stores inventory stage
 The work- in- progress stage
 The finished goods inventory stage
 The receivable stage
The operating cycle begins with the arrival of the stock, and ends when the
cash is received. The cash cycle begins when cash is paid for materials, and
ends when cash is collected from receivables.
Fig 1.3 Operating working Capital Cycle

Importance of Operating Cycle Concept - The application of operating
cycle concept is mainly useful to ascertain the requirement of cash working
capital to meet the operating expense of a going concern. This concept is
based on the continuity of the flow of value in a business operation.
This is an important concept because the longer the operating cycle, the more
working capital funds the firm needs. Management must ensure that this cycle
does not become too long. This concept precisely measures the working capital
fund requirements, traces its changes and determines the optimum level of
working capital requirements.
1. The ___________refers to the average time elapses between the ac-
quisition of raw materials and the final cash realization.
126
a. annual cycle
WORKING CAPITAL
b. operating cycle MANAGEMENT - I
2. Wages are paid and other ____________are incurred in the process
and work-in-process comes into existence.
a. Expenses
b. Saving
Components of operating cycle
Gross Operating cycle: The following components are of gross operating
cycle:
1. R = Raw material Storage Period
2. W = Work In Progress Holding Period
3. F = Finished Goods Storage Period
4. D = Debtors Collection Period Allowed
Thus gross Operating cycle = R + W + F+D
Net Operating Cycle = net operating cycle means Gross operating cycle
minus Credit period allowed by suppliers (creditors) of goods.
1. R = Raw material Storage Period
2. W = Work In Progress Holding Period
3. F = Finished Goods Storage Period
4. D = Debtors Collection Period Allowed
5. C = Credit Period allowed by suppliers
Thus Net Operating Cycle = R + W + F + D - C
How to calculate components of operating cycle :
The following formulas are to be used for different components to determine
operating cycle.
N o C omp on ent Fo rmula s
1 A vera ge R aw Ma te ria l A ver ag e Sto ck o f R aw Ma te ri al / Aver ag e Co st o f Ra w Mate ria l
S to rag e Per iod In D ays Con sum ption Pe r Da y
2 Avera ge W ork in Process A ve ra ge Stock of W or k in Prog ress / Ave rag e Cost o f Wo rk in
H old ing P er iod in Days Pro cess P er Day
3 Avera ge Finishe d Go ods Aver ag e Stock of Finish ed G o ods / A ver ag e Cost of G o ods
S tora ge P erio d In Da ys Pro du ced Pe r Day
4 Ave ra ge Deb tor 's Aver ag e Trad e De btors / A ver age Cost o f Cr ed it S ale s Per Da y
C oll ectio n Pe rio d in D ays
5 Av er ag e C re d itor's Aver ag e Trad e Cre dito rs / Ave rag e Co st of Cre dit Pu rcha se Pe r Day
p a ym en t Pe rio d in Da ys
6 A vera ge Tim e La g in Ave rag e Cr ed itors for E xpe nse s/ Aver ag e Expe nse Per D ay
P a ym en t o f e xpe nse s in
Days
How to calculate Number of Operating Cycles in a Year?

The number of Operating Cycle in a year may be calculated as follows:
No of Operating Cycles in a year = No of days in a year / Net Operating cycle
127
WORKING CAPITAL (In days)
MANAGEMENT AND Illustration:
INVESTMENT
From the following information of Shukla LTD calculate: (1) Gross Operat-
ing Cycle (2) Net Operating Cycle and (3) No of Operating cycles in a year
No Pa rticu lars Am ou nt in Rs
1 Ra w Ma te ri al Co nsu mp tion du rin g th e ye ar 6 0,00 ,0 00
2 A ve ra ge S to ck o f Ra w Mate rial 1 0,00,00 0
3 Factory C ost of G oo ds P rod uced 1 ,0 5,00,00 0
4 Avera ge stock of W I P 4 ,3 7,5 00
5 O ffice Cost of G oo ds Pro du ce d 1,14,00 ,00 0
6 Ave rag e Stock of Fi nishe d Go od s 9 ,5 0,00 0
7 A vera ge tr ad e De btor s 11,25 ,0 00
8 Cost of Cr edit S ales 9 0,00 ,0 00
9 A ve ra ge Tr ade C red itors 5 ,0 0,00 0
10 E xpen ses for the Ye ar 30,00 ,000
11 Ave rag e Cre ditors fo r Expe nse s 5 ,0 0,00 0
NO TE: No W orking Days in a Yea r ( Assume 360 Da ys)
Answer:
No Component Formulas Amount in Rs Days
1 Average Raw Material Storage Average Stock of Raw Material / 10,00,000 / ( 60,00,000 60
Period In Days Average Cost of Raw Material /360 )
Consumption Per Day
2 Average Work in Process Average Stock of Work in 4,37,500/(1,05,00,000 15
Holding Period in Days Progress / Average Cost of Work /360 )
in Process Per Day
3 Average Finished Goods Average Stock of Finished Goods 9,50,000 / 30
Storage Period In Days / Average Cost of Goods (1,14,100,000/360)
Produced Per Day
4 Average Debtor's Collection Average Trade Debtors /Average 11,25,000 /( 90,00,000 45
Period in Days Cost of Credit Sales Per Day /360 )
5 Avera ge Creditor's pa yment Average Trade Creditors / 5,00,000 / ( 60,00,000 / 30
Period in Days Average Cost of Credit Purchase 360)
Per Day
6 Average Time Lag in Payment Average Creditors for Expenses/ 5,00,000 / ( 30,00,000 / 60
of expenses in Days Average Expense Per Day 360)
1) Gross Operating Cycle: R + W + F + D

60 +15 + 30 + 45 = 150 Days
2) Net Operating Cycle: R + W + F + D-C
60 + 15 + 30 + 45 - 30 - 60 = 60 Days
3) No of Operating cycles in a year = No of days in a year / Net Operating
cycle
= 360 Days / 60days
= 6 Operating Cycles
1.6 Working Capital Requirements
Every firm requires at least some amount of working capital, only their work-
ing capital requirements are different. The goal of every firm should be to
increase the profit of its shareholders. And to achieve this goal, the firm’s
operations must yield enough returns. Successful sales activity is very essen-
tial to earn profit and hence, it is imperative that a firm invests sufficient funds
128
in its current assets for sales generation. As sales cannot be converted into
WORKING CAPITAL
cash immediately, current assets are required to convert sales into cash.
MANAGEMENT - I
Working capital is essentially circulating capital; in fact it is often referred to
as such. This has been admirably summed up by comparing it with ariver
which is there every day, but the water in it is constantly changing.
The required amount of working capital in relation to the fixed capital of a
business will vary widely between firms in different industries. For example,
a company engaged in the ship-building industry will need a large amount of
fixed or long term capital to finance the shipyard, equipment, etc for consid-
erable periods, whereas a jobbing builder will require virtually no fixed as-
sets but instead a reasonably large amount of working capital to finance stocks
of parts, amounts owing by customers, etc. If company does not have enough
working capital it will soon find its activities restricted. Many firms which
seemed to be expanding their activities successfully have faced trouble through
insufficient working capital being available to finance this expansion. Under
normal conditions a steady increase in working capital indicates a successful
business, while a steady decrease would be a danger signal demanding im-
mediate action to remedy the situation
Both in practice and in examinations, the question is often asked:
What will be the working capital requirements to finance this level of activity
or that new project? This is a very practical and important problem which
may require extensive research and difficult calculations. However, to show
the usual requirements in simple form, the following items are tabulated:
 The cost of raw materials, wages and overheads.
 The period during which raw materials will remain in stock before is-
sue to production.
 The period during which the product will be processed through the
factory.
 The period during which finished goods will remain in the warehouse.
 The lag in payment to suppliers of raw materials and service.
 The lag in payment to employees.
 The lag in payment by debtors.
 Frequently an amount is allowed to cover contingencies, e.g. 10% might
be added to the total amount.
Most of these points will be included in a computation of working capital
requirements. For example, the period during which stocks of finished goods
stay in the warehouse can only be an average figure, but by careful observa-
tion it should be possible to make a reasonable assessment. This is the reason
for allowing an amount to cover contingencies: it is hoped that this figure
might cover any inaccuracies in calculation.
1. The required amount of __________in relation to the fixed capital of a
business will vary widely between firms in different industries.
129
WORKING CAPITAL a. capital
MANAGEMENT AND b. working capital
INVESTMENT
2. ____________is essentially circulating capital; in fact it is often re-
ferred to as such.
a. Market Capital
b. Working capital
1.7 Estimating Working Capital Needs and Financing Current Assets
Operating cycle is the most appropriate method for computing the working
capital requirements of any company. However, methods other than operat-
ing cycle for computing a firm’s working capital include:
 Estimation of a firm’s working capital requirements on the grounds of
its current assets' average holding period and then relating them to the
company’s costs based on past experiences. Operating cycle approach
forms the basis of this method. In order to use this method for estimat-
ing working capital needs, one can make certain assumptions such as
there is a supply of raw materials and semi finished and finished goods
for one month.
 Assuming that the current assets vary with sales, the ratio of sales can
be used as a method for estimating the working capital of a firm. Here,
it can be assumed that the annual sales are anywhere between 25-30 %.
 Working capital requirement can also be estimated as a ratio of fixed
investments.
One can assume the firm’s capital investment to be 10-20% in order to use
this method.
As the second approach is clearly dependant on how accurately the sales are
estimated, this method is less reliable. Likewise, the third method is highly
dependent on the investment estimates. If the investments are not estimated
properly, then it will affect the estimation of working capital needs using this
method and hence, this method is not used generally.
Various factors like the accurate sales and investment forecasting, alterations
in operations etc. should be considered while estimating a firm’s working
capital requirements. Also, other factors like the company’s production cycle,
its collection policies etc. should also be taken into consideration.
Financing Current Assets
The various policies for financing current assets include
 Long-term financing can be obtained by means of debentures, ordinary
as well as preference share capital, long term loans coming from banks
and financial institutions etc.
 Short-term financing can be sourced in the form of working capital
coming from banks, commercial papers, public deposits etc. Short-term
130
finance is obtained from short-term suppliers in money market as well
WORKING CAPITAL
as from banks and is generally for a period less than one year.
MANAGEMENT - I
The automatic funds arising in day-to-day business are referred to as Spon-
taneous financing. Outstanding expenses, trade credit etc. are some of the
examples of spontaneous financing. A firm is expected to use this source of
financing to the fullest extent as there are no explicit costs associated with
this type of financing.
1. Operating cycle is the most appropriate method for computing the
__________requirements of any company.
a. working capital
b. asset
2. ______________requirement can also be estimated as a ratio of fixed
investments.
a. Working capital
b. Estimate capital
1.8 Strategies in Working Capital Management
So far the banks were the sole source of funds for working capital needs of
business sector. At present more finance options are available to a Finance
Manager to see the operations of his firm goes smoothly. Depending on the
risk exposure of business, the following strategies are evolved to manage the
working capital.
Conservative Approach
A conservative strategy suggests not taking any risk in working capital man-
agement and carrying high levels of current assets in relation to sales. Sur-
plus current assets enable the firm to absorb sudden variations in sales, pro-
duction plans, and procurement time without disrupting production plans. It
requires to maintain a high level of working capital and should be financed by
long-term funds like share capital or long-term debt. Availability of sufficient
working capital will enable the smooth operational activities of the firm and
there would be no stoppages of production for want of raw materials,
consumables. Sufficient stocks of finished goods are maintained to meet the
market fluctuations. The higher liquidity levels reduce the risk of insolvency.
But lower risk translates into lower return. Large investments in current
assets lead to higher interest and carrying costs and encouragement for inef-
ficiency. But conservative policy will enable the firm to absorb day to day
business risk. It assures continuous flow of operations and eliminates worry
about recurring obligations. Under this strategy, long-term financing covers
more than the total requirement for working capital. The excess cash is in-
vested in short-term marketable securities and in need these securities are
sold-off in the market to meet the urgent requirements of working capital.
Financing Strategy
Long-term funds = Fixed assets + Total permanent current assets + Part of
131
WORKING CAPITAL temporary current assets
MANAGEMENT AND Short-term funds = Part of temporary current assets
INVESTMENT
Aggressive Approach
Under this approach current assets are maintained just to meet the current
liabilities keeping any cushion for the variations in working capital needs.
The core working capital is financed by long-term sources of capital and
seasonal variations are met through short-term borrowings. Adoption of this
strategy will minimize the investment in net working capital and ultimately it
lowers the cost of financing working capital. The main drawback of this strat-
egy is that it necessitates frequent financing and also increases risk as the firm
is vulnerable to sudden shocks. A conservative current asset financing strat-
egy would go for more long-term finance which reduces the risk of uncer-
tainty associated with frequent refinancing. The price of this strategy is higher
financing costs since long-term rates will normally exceed short term rates.
But when aggressive strategy is adopted, sometimes the firm runs into mis-
matches and defaults. It is the cardinal principle of corporate finance that
long-term assets should be financed by long-term sources and short-term
assets are a mix of long and short-term sources.
Financing Strategy
Long-term funds = Fixed assets + Part of permanent current assets
Short-term funds = Part of permanent current assets + Total temporary cur-
rent assets
Matching Approach
Under matching approach to financing working capital requirements of a
firm, each asset in the balance sheet assets side would be offset with the
financing instrument of the same approximate maturity. The basic objective
of this method of financing is that the permanent component of current
assets,and fixed assets would be met with long-term funds and the short-term
or seasonal variations in current assets would be financed with short-term
debt. If the long-terra funds are used for short-term needs of the firm it can
identify and take steps to correct the mismatch in financing. Efficient work-
ing capital management techniques are those that compress the operating
cycle. The length of the operating cycle is equal to the sum of the lengths of
the inventory period and the receivables period. Just-in-time inventory man-
agement technique reduces carrying costs by slashing the time that goods are
parked as inventories. To shorten the receivables period without necessarily
reducing the credit period, corporate can offer trade discounts for prompt
payment. This strategy if also called as ‘hedging approach’.
Financing Strategy
Long-term funds = Fixed assets + Total permanent current assets Short-term
funds = Total temporary current assets]
Zero Working Capital Approach
This is one of the latest trends in working capital management. The idea is to
have zero working capital i.e., at all times the current assets shall equal the
current liabilities. Excess investment in current assets is avoided and firm
132
meets its current liabilities out of the matching current assets. As current
WORKING CAPITAL
ratio is 1 and the quick ratio is below 1, there may be apprehensions about
MANAGEMENT - I
the liquidity, but if all current assets are performing and are accounted at
their realizable values, these fears are misplaced. The firm saves opportunity
cost on excess investments in current assets and as bank cash credit limits are
linked to the inventory levels, interest costs are also saved. There would be a
self-imposed financial discipline on the firm to manage their activities within
their current liabilities and current assets and there may not be a tendency to
over borrow or divert funds. Zero working capital also ensure a smooth and
uninterrupted working capital cycle, and it would pressurise the Financial
Management to improve the quality of the current assets at all times to keep
them 100% realizable. There would also be a constant displacement in the
current liabilities and the possibility of having over dues may diminish. The
tendency to postpone current handily payments has to be curbed and work-
ing casual always maintained at zero. Zero working capital would call for a
fine balancing act in Financial Management, and the success in this endeav-
our would get reflected in healthier bottom lines.
Total Current Assets = Total Current Liabilities or Total Current Assets-
Total Current Liabilities = Zero
Working Capital Policies
The degree of current assets that a company employs for achieving a desired
level of sales is manifested in working capital folio. In practice, the business
concerns follow three forms of working capital policies which are discussed
in brief as follows:
Restricted Policy: It involves the rigid estimation of working capital to the
requirements of the concern and then forcing it to adhere to the estimate.
Deviations from the estimate are not allowed and the estimate will not pro-
vide for any contingencies or for any unexpected events.
Relaxed Policy: It involves the allowing of sufficient cushion for fluctua-
tions in kinds of requirement for financing various items of working capital.
The estimate is made after taking into account the provision for contingen-
cies and unexpected events.
Moderate Policy The relationship of sales and corresponding level of in-
vestment in current assets is shown in figure.
1.9 Estimation working capital :
Illustration 1
From the following details you are required to make an assessment of the
average capital requirement of Hindustan Ltd.
133
WORKING CAPITAL Particulars Average Estimate for
MANAGEMENT AND period of the 1s t year
INVESTMENT credit (R)
Purchase of material
6 weeks 26,00,000
Wages 1½ Weeks 19,50,000
Overheads:
Rent, Rates, etc 6 months 1,00,000
Salaries 1 month 8,00,000
Other overheads 2 months 7,50,000
Sales cash 2,00,000
Credit sales 2 months 60,00,000
Average amount of stocks and work-in- 4,00,000
progress
Average amount of un drawn profit 3,00,000
It is assumed that all expenses and income were made at even rate for the
year Assessment of Average amount of working capital Requirement
Current Assets
Stock and work-in-process 4,00,000
Debtor (R 60,00,000 × 2/12) 10,00,000
(a) 14,00,000
Current Liabilities:
Lag in payments:
Purchases (R 26,00,000 × 6/52) 3,00,000
Wages (R 19,50,000 × 1.5/52) 56,250
Rent (R 1,00,000 × 6/12) 50,000
Salaries (R 8,00,000 × 1/12) 66,667
Other overheads (R 7,50,000 × 2/12) 1,25,000
(b) 5,97,917
Total Working Capital (a) – (b) 8,02,083
Less: Average amount of 3,00,000
un drawn profit
Net Working 5,02,083

Capital Required
Illustration 2
Estalla Garment Co. Ltd is a famous manufacturer and exporter of garments
to the European countries. The Finance Manager of the company is prepar-
ing the working capital forecast for the next year. After carefully screening
the entire document he collected the following information -
134
Production during the previous year was 15,00,000 units. The same level of
WORKING CAPITAL
activity is intended to be maintained during the current year. The expected
MANAGEMENT - I
ratios of cost to selling price are:
Raw material 40%
Direct wages 20%
Overheads 20%
The raw materials ordinarily remain in stores for 3 months before produc-
tion. Every unit of production remains in the process for 2 months and is
assumed to be consisting of 100% raw material, wages and overheads. Fin-
ished goods remain in warehouse for 3 months. Credit allowed by the credi-
tors is a month from the date of the delivery of raw material and credit given
to debtors is 3 months from the date of dispatch.
Estimated balance of cash to be held R 2, 00,000
Lag in payment of wages 1/2 month
Lag in payment of expenses 1/2 month
Selling price is R 10 per unit. Both production and sales are in a regular
cycle.You are required to make a provision of 1.0% for contingency (except
cash).Relevant assumptions may be made. You have recently joined the com-
pany as an Assistant Finance Manager. The job of preparing the forecast
statement has been given to you. You are required to prepare the forecast
statement. The Finance Manager is particularly interested in applying the
quantitative techniques for forecasting the working capital needs of the
company.
Answer:
Monthly production = 15,00,000 Units /12 Months = 1,25,000 Units
Classification of selling price:
Selling price Rs. 10
Direct Material 40% of selling price Rs 4
Direct Labour 20% of selling price Rs 2
Overheads 20% of selling price Rs 2
Total cost Rs 8
Profit 2
Statement of working capital requirement
A Current Assets: Rs Rs
Cash 2,00,000
Direct Material 1,25,000 * 3 Months * Rs 4 15,00,00
Work in process: Direct Material 1,25,000 * 2 Months * Rs 4 * 10,00,00 20,00,00
100% completed Direct Labour 1,25,000 * 2 Months * Rs 2 * 0 0
50% completed Overheads 1,25,000 * 2 Months * Rs 2 * 50% 5,00,000
completed
Finished Goods 1,25,000 * 3 Months * Rs 8 5,00,000 30,00,00
Debtors 1,25,000 * 3 Months * Rs 8 30,00,00
97,00,00
B Current Liabilities: 0
Creditors of Goods 1,25,000 1 Month * Rs 4 5,00,000
Wages 1,25,000 * 1/2 Month Rs 2 1,25,000
Overheads 1,25,000 * 1/ 2 Month Rs 2 1,25,000 7,00,000
C A - B Net Working Capital 97,00,00
135
WORKING CAPITAL Illustration : 3
MANAGEMENT AND The following information is obtained from the records of X LTD. The
INVESTMENT working capacity of the company is 1,56,000 units. You are asked to prepare
statement of working capital.
Particulars Rs. Per unit
Raw material 90
Direct Labour 40
Overheads 75
Cost Per unit 205
Profit 60
Selling Price 265
Additional Information:
a) Raw material are in stock on average of one month.
b) Materials are in process, on average 2 weeks. From the view point of
material it is 100% completed and from the view point of labour and
overheads it is completed by 50%.
c) Finished goods are in stock, on average one month.
d) Credit allowed by suppliers - One month.
e) Time lag in payment from debtors - 2 months.
f) Lag in payment of wages-1.5 weeks.
g) Lag in payment of overheads - one month.
20% sales are on cash basis. Cash in hand and bank is expected to be Rs.
60,000. It is to be assumed that production is carried on evenly throughout
the year. Wages and overhead accrue similarly and a time period of 4 weeks is
equivalent to a month.
Answer: Working Note :
No Components of working capital Rs Rs.
1 Raw Material l,56,000/52Weeks * 4weeks * Rs . 10,50,000
2 90 = In Process: l,56,000/52Weeks * 2 Weeks = 5,40,000
Work 8,85,000
6000 Units Raw Material (6000 Units* Rs 90) 1,20,000
Direct Labour (6000 Units* Rs 40*0.5 Week) 2,25,000
Overheads (6000Units * Rs75* 0.5 Week)
3 Finished Goods: 1,56,000 Units/52Weeks 24,60,000
*4Weeks Rs 205
4 Debtors: 1,56,000 Units /52 Weeks * 8Weeks * 39,36,000
Rs 205 * 80/100
5 Creditors: 1,56,000 units/52 weeks * 4 weeks 10,80,000
6 *Rs
Wages901,56,000 units/52 weeks *1.5 weeks * Rs 1,80,000
7 40
Expenses: 1,56,000 units/52 weeks *4 weeks *Rs 9,00,000
75
136
Statement of working capital requirement
WORKING CAPITAL
P ar tic ulars Rs Rs MANAGEMENT - I
(A) C urrent asset s:
Cas h in hand and cas h at ba nk 60,000
St ock in hand: R aw m at eria l 10,80,000
W o rk in P roces s 8,85,000
F inished goods 24,60,000 44,25,000
Sundry debt ors 39,36,000
84,21,000
(B ) C urre nt Li abil it ies :
Sundry C reditors 10,80,000
W ages payable 1,80,000
Expenses payable 9,00,000
21,60,000
( C ) (A ) - (B ) Ne t W or ki n g 62,61,000
C api tal
Illustration : 4
Prepare statement of working capital requirement from the following
information:
Particulars Period Amount (Rs)
Purchased of Raw Material 6 Weeks 13,00,000
Wages 1.5 Weeks 9,75,000
Overheads: Rent 6 Months 50,000
Salaries 1 Month 4,00,000
Other overheads 2 Months 3,75,000
Sales Cash 1,00,000
Credit Sales 2 Months 30,00,000
Average amount of stocks and work in 2,00,000
process
Note:It is assumed that all expenses and income were made at even rate for
the year. Statement of working capital requirement
Pa rti cu l ar s R s.
(A ) C u rr en t A s s e ts:
S to ck a nd w o rk in p r o ce ss 2 ,0 0 ,0 0 0
D eb to r s (R s 3 0 ,0 0 ,0 0 0 *2 /1 2 ) 5 ,0 0 ,0 0 0
7,0 0 ,00 0
(B ) C u rr e n t lia b i lit ies :
Pu rch as es ( R s. 1 3 ,0 0,0 0 0 *6 /5 2 ) 1 , 5 0 ,0 0 0
W ag e s (R s. 9 ,75 ,0 0 0 * 1 .5 /5 2 ) 2 8 ,1 2 5
R en t (R s 5 0 ,0 0 0 * 6 /1 2) 2 5 ,0 0 0
Sa lar ie s( R s.4 ,0 0 ,0 0 0 * l/ 1 2 ) 3 3 ,3 3 3
O t h er O ve r he a d s (R s. 3 ,7 5 ,0 0 0 * 2/ 1 2 ) 6 2 ,5 0 0
2 ,9 8,9 5 8
( C ) = (A ) - (B ) N et W o rkin g C a pita l 4 ,01 ,0 42
137
WORKING CAPITAL Check your progress 8
MANAGEMENT AND 1. In simple words, __________ is a force applied at a particular point to
INVESTMENT get the desired result.
a. Asset
b. Leverage
2. ___________is a tool with which a financial manager can maximize the
return to the equity shareholders
a. Financial leverage
b. management
1.10 Let Us Sum Up
In this unit we have discussed the importance of working capital in detail.
In this unit we studied that the working capital is circulating capital. In healthy
human body proper circulation of blood is necessary, similarly in healthy busi-
ness adequate circulating capital is necessary. Working capital requirements
vary from industry to industry.Capital structure decision lead either to high
gearing or low gearing.We even had a discussion on business risk and studied
that business faces business risk which is measured by operating leverages. It
also faces financial risk if it borrows on long term basis this is measured by
financial leverages. We eve studied about working capital management and
studied that it includes management of various components of current assets
as well as current liabilities. The various types of working capital were also
discussed over here.
There are different policies for financing current assets. Types of working
capital include Net working Capital, Gross Working Capital, Permanent Work-
ing Capital, Temporary or Variable Working Capital, Balance sheet working
capital, Cash working capital and Negative working Capital.We even dis-
cussed the Factors determining working capital and studied that these factors
include Nature of Industry, Demand of Industry, Cash Requirements, Nature
of Business, Time, Volume of Sales, Terms of purchase and Sales, Inventory
Turnover, Receivable Turnover, Business Turnover, Business Cycle, Volume
of Current Assets, Variation of Sales, Production Cycle, Credit Controls, Li-
quidity and Profitability, Inflation, Seasonal Fluctuations, Profit Planning and
Control, Repayable Ability, Cash Reserves etc. We even studied the operat-
ing cycle and studied that operating cycle consists of four stages: The raw
materials and stores inventory stage, the work- in- progress stage, the fin-
ished goods inventory stage and the receivable stage. There are some inter-
nal, external and general factors which affect the capital structure decisions.
We also covered the concept of leverages and its types – Operating, Financial
and combined leverage.
This unit is going to be of great help for the students in understanding the
concept of working capital and various other concepts associated with it.
138
1.11 Answers for Check Your Progress WORKING CAPITAL
Check your progress 1 MANAGEMENT - I
Answers: (1-b), (2-a)
Answers: (1-b), (2-b), (3-a)
Answers: (1-b), (2-a),
Answers: (1-b), (2-b)
Answers: (1-a), (2-a)
1.12 Glossary
1. Working Capital -A firm’s investment in short-term assets—cash, mar-
ketable securities, inventory, and accounts receivable.
1.13 Assignment
Explain the concept of leverage and its types.
1.14 Activities
What are the various factors that will affect the requirement of working
capital ?
1.15 Case Study
Visit a manufacturing company in your city and understand the working capital
management of the company.
1. Financial Management - R V Kulkarni
2. Financial Management - Prof. Dr. Mahesh A. Kulkarni
3. Financial Management – Ravi M. Kishore
4. Management Accounting for T.Y. B.Com. By Chopda Chaudhary
5. Financial Management - ICFAI
139
WORKING CAPITAL
MANAGEMENT AND Unit WORKING CAPITAL MANAGEMENT - II
INVESTMENT
2
: UNIT STRUCTURE :
2.1 Introduction
2.2 Inventory Management
2.2.1 Purpose of Holding Inventories
2.2.2 Types of Inventories
2.2.3 Inventory Management Techniques
2.2.4 Pricing of Inventories
2.3 Receivables Management
2.3.1 Purpose of Receivables
2.3.2 Cost of Maintaining Receivables
2.3.3 Monitoring Receivable
2.4 Cash Management
2.4.1 Reasons for Holding Cash
2.4.2 Factors for Efficient Cash Management
2.5 Let Us Sum Up
2.7 Glossary
2.8 Assignment
2.9 Activities
2.10 Case Study
 Discuss inventory management
 Explain Receivables management
 Practise cash management techniques
 Know the purpose of inventory
 List inventory management techniques
2.1 Introduction
Inventories form a major chunk of current assets of a company and huge
amount of funds are often invested in them. Hence, it is extremely important
that a firm manages its inventories in an efficient and most effective manner.
140
2.2 Inventory Management WORKING CAPITAL
Inventories are asset items held for sale in the ordinary course of business or MANAGEMENT - II
goods that will be used or consumed in the production of goods to be sold.
The description and measurement of inventory require careful attention be-
cause the investment in inventories is frequently the largest current asset of
merchandising (retail) and manufacturing businesses.
An inventory can be defined as the raw materials, work-in-process goods
and completely finished goods that are considered to be the portion of a
business’s assets that are ready or will be ready for sale. Inventory represents
one of the most important assets that most businesses possess, because the
turnover of inventory represents one of the primary sources of revenue gen-
eration and subsequent earnings for the company’s shareholders/owners
2.2.1 Purpose of Holding Inventories
Keeping the stock of inventories involves locking of the company’s funds
and increase in storage and handling costs. Companies hold inventories basi-
cally for 3 motives
 Transactions motive i.e. to ensure smooth production and sales opera-
tions.
 Precautionary motive i.e. to guard against the volatility of demand and
supply factors.
 Speculative motive which is done to take benefit of price fluctuations.
Let us see inventory as a components of working capital.
2.2.2 Types of Inventories
The various forms of inventories include
 Raw material inventories are the ones that form the basic ingredients
to be converted into finished products by means of manufacturing pro-
cess. A company buys and stores the raw materials to be used later.
 Work-in-process inventories are semi-finished goods and require more
processing before becoming finished goods that are ready for sale.
 Finished goods inventoriesare completely ready products that can be
sold.
 Other than above three basic inventories, there is one more inventory
type called as supplies, also known as stores and spares. Though they
are not directly into production, but are required for the process of
production. Examples of supplies are materials like soaps, brooms, oil,
fuel, light etc.
Inventory Management aims at reducing the direct and indirect costs that are
associated with the inventory. It also includes maintaining an appropriate
and sufficient inventory supply for the smooth production and sales activi-
ties. The severity of inventory management of a firm depends upon the ex-
tent to which the firm has invested in inventories. An ideal and efficient in-
ventory management -
141
WORKING CAPITAL  Must ensure that the raw materials are supplied at the right time and
MANAGEMENT AND quantities for smooth production operations.
INVESTMENT  Should anticipate price fluctuations and accordingly keep enough sup-
ply of raw materials in times of shortage.
 Maintain a healthy supply of finished goods for better customer service
as well as smooth sales activities
 Reduce the carrying time and expenses
 Exercise control over investments made in inventories.
2.2.3 Inventory Management Techniques
 Economic Order Quantity (EOQ)
 Reorder Point
 Stock Level
Economic Order Quantity (EOQ)
The Economic Order Quantity is the optimal order size that results in the
lowest total of order and carrying cost for an item of inventory given its
expected usage, carrying cost and ordering cost. The EOQ determines the
order size which will minimize the total inventory cost.
2 (Annual usage in units) (Order cost)

EOQ =
(Annual carring cost per unit)
Total Inventory Cost = Ordering Cost + Carrying Cost

The ordering cost includes the cost of acquiring raw material. It includes the
activities like purchase ordering, transporting, storing and inspecting.
The carrying cost is the cost incurred for maintaining a given level of inven-
tory.
Examples :
 Size of order (units) : 300
Number of orders in a year : 8
Total ordering cost at R 100 per order = 800
Number of orders in a year: 6
Number of orders in a year: 4
From the above examples, we can see that a company can reduce its total
ordering cost by increasing the order size which will reduce the number of
orders.
EOQ Formula
= (2AO / C ) i.e sqroot (2AO / C)

142
where A = total requirement
WORKING CAPITAL
O = order cost MANAGEMENT - II
C = carrying cost
Example:
The total requirement is 2000 units. Ordering cost per order is R 40 and
carrying cost per unit is R 2. The EOQ will be
EOQ = (2 × 2000 × 40 / 2)
= 282.84
= 283 units
Reorder point
After EOQ, the second technique for inventory management is reorder point
where the reorder point is the inventory level at which an order should be
given to restock the inventory. To decide the reorder point, we should know
 Lead time
 Average usage
 Economic order quantity
Lead time is the time taken to restock the inventory once the order is given.
Reorder point = Lead time X Average usage
Suppose, EOQ = 1000 units and the lead time is 4 weeks and average usage
is 100 units per week. Here the new order should be placed at the end of 10th
week. But as there is lead time of 4 weeks, the order should be placed at the
end of 6th week. So, here the reorder point = 100 units X 4 weeks = 400
units.
Stock Level
This technique keeps track of the goods the company has, the issue of goods
and the receipt of orders. It keeps track of the level of inventory it has. If this
technique or system reports that an item is at or below the reorder point
level, the firm places an order for the item.
2.2.4 Pricing of Inventories
Following are the different ways of valuing the inventories and these meth-
ods are important to have an efficient inventory management process. These
methods are used to value the raw materials:
 First-in-first-out (FIFO)
 Last-in-first-out (LIFO)
 Weighted Average Cost method
 Standard Price method
 Replacement or Current Price method
143
WORKING CAPITAL Inventory Pricing
MANAGEMENT AND
Income Statement Balance Sheet
INVESTMENT Method Assumption
Effect Effect
FIFO When a company The older inventory The remaining
sells an item from was cheaper, so cost inventory carried on
inventory the oldest of sale is less and the balance sheet is
one is sold income is higher the newest, and most
valuable
LIFO When an item is The never (more Remaining inventory
sold from inventory expensive) inventory is shown as an older
the newest one is is sold, so the cost of and less valuable
sold sales is higher and asset
income is lower
Average The average cost of Both cost of sales Inventory asset will
cost all inventory is used and income will be be between the
for both cost of between the levels levels recorded
sales and inventory recorded under under LIFO or FIFO
LIFO or FIFO
Source- Inventory Accounting Methods: LIFO, FIFO, Weighted Average and

Specific Identification, financial-education.com
 First-in-first-out (FIFO): In this method, the raw materials from the
stores will be issued in the order in which they are received. Hence, the
cost of material obtained first will determine the pricing in this method.
 Last-in-first-out (LIFO): In LIFO method, the recently purchased
material will determine the price of the issued material.
 Weighted Average Cost Method: The issued material will be priced
purely on the basis of weighted average where, the weights will be
decided based on the quantity.
 Standard Price method: In this method, a predetermined standard
cost will be used to price the issued material. On purchase of the mate-
rial, this standard price will be deducted from the stock account.
 Replacement / Current Price method: This method prices the mate-
rial at the value that is realized at the time of issuance.
1. The __________is the optimal order size that results in the lowest total
of order and carrying cost for an item of inventory given its expected
usage, carrying cost and ordering cost.
a. LIFO
b. Economic Order Quantity
2. The __________the order size which will minimize the total inventory
cost.
a. Economic Order
b. EOQ determines
144
2.3 Receivables Management WORKING CAPITAL
To increase the sales from the customers who cannot borrow from other MANAGEMENT - II
sources, the companies generally sell goods on credit. If the credit is given to
the customers and when such finished goods are sold, they get converted
into receivables which in turn can be converted into cash. The balance in the
receivables account is – average daily credit sales X average collection pe-
riod.
Let’s say, if the average daily credit sales of a firm is R 5,00,000 and the
average collection period is 30 days, the average balance in the receivables
account would be
5,00,000 × 30 = R 1,50,00,000.
In many organizations, receivables form an important part of the total assets.
Receivables management is time consuming for the finance manager.
2.3.1 Purpose of Receivables
In order to understand the purpose of receivables, it is very important to
understand the main aim of receivables management. The primary aim of
receivable management is promotion of sales and gains till a certain limit
where the returns obtained by funding of receivables is less than the cost that
the company is required to incur in order to fund these receivables. So, the
purpose of receivables include
 Maximizing the sales by selling the goods on credit rather than insist-
ing on immediate payment of cash.
 When the goods are sold on credit, higher profit margins are charged
unlike cash sales, resulting in increased profits.
 In today’s competitive world, the company will have to give better
credit terms than offered by its competitors.
2.3.2 Cost of Maintaining Receivables
1. Blockage of additional funds: If the firm is granting credit to the
customer, then there would be some time lag between the credit sale to
the customer and receipt of cash from the customers. Since additional
funds are required to maintain these receivables, the company has to
manage the finances required for other purposes. Since the company
has to invest in additional funds, the outgo will be in the form of inter-
est or the opportunity cost of funds.
2. Maintenance cost: Since the company is into receivables manage-
ment, it has to incur additional expenses in the form of clerk salary,
investigation of the debtors, credit checks. In short, the administrative
cost will increase due to the receivables management.
3. Defaulting cost: Many times the company incurs loses from bad debts.
The bad debts are result of default in payments by the customers who
were offered credit.
4. Collection cost: Collection costs are the costs which are incurred for
the collection of money from the customers at the right time.
145
WORKING CAPITAL Exhibit: Why do companies in India grant credit?
MANAGEMENT AND Companies in practice feel the necessity of granting credit for several
INVESTMENT reasons.
 Competition: Generally, the higher the degree of competition, the more
credit is granted by a firm. However, there are exceptions such as firms
in the electronics industry in India.
 Company’s bargaining power: If a company has a higher bargaining
power vis-à-vis its buyers, it may grant no or less credit. The company
will have a strong bargaining power if it has a strong product, mo-
nopoly power, brand image, large size or strong financial position.
 Buyer’s requirements: In a number of business sectors, buyers/deal-
ers are not able to operate without extended credit. This is particularly
so in the case of industrial products.
Buyer’s status
Large buyers demand easy credit terms because of bulk purchases and higher
bargaining power. Some companies follow a policy of not giving much credit
to small retailers since it is quite difficult to collect dues from them.
 Relationship with dealers: Companies sometimes extend credit to deal-
ers to build long term relationships with them or to reward them for
their loyalty.
 Marketing tool: Credit is used as a marketing tool, particularly when
a new product is launched or when a company wants to push its weak
product.
 Industry practice: Small companies have been found guided by indus-
try practice or norms more than the large companies. Sometimes com-
panies continue giving credit because of past practice rather than indus-
try practice.
 Transit delays: This is a forced reason for extended credit in the case
of a number of companies in India. Most companies have evolved sys-
tems to minimize the impact of such delays. Some of them take the help
of banks to control cash flows in such situations.
2.3.3 Monitoring Receivable
In order to ensure the efforts put into collections, a firm should continuously
monitor its payment of receivables. The four methods for managing receiv-
ables are –
1. Average collection period (ACP)
2. Ageing schedule.
3. Days Sales Outstanding
4. Collection Matrix
1. Average collection period (ACP)
The average collection period is primarily based on outstanding receivables
on year-end. In order to exercise internal control, monitoring should be done
frequently. If the sales are seasonal or tend to grow towards the year-end,
then, the outstanding balance at the end of year can be misleading.
146
2. Ageing schedule
WORKING CAPITAL
Ageing schedule depicts the age-wise distribution of accounts receivable at MANAGEMENT - II
any particular time. In other words, the receivables are broken down based
on the time period for which they have been outstanding.
The behavioural changes in the payments made by customers can be easily
identified by comparing the ageing schedules periodically.
The ageing schedule can be compared with the company’s extended credit
period.
If the degree of receivables that belongs to high-age groups is found to be
above the stipulated norm, then suitable action should be taken before it
turns into bad debts.
3. Days Sales Outstanding
The average number of days sales outstanding at any particular period of
time say at the end of a quarter or at the end of the month can be given by the
following formula.
Days sales outstanding (DSO) = Accounts receivable at a particular time
/ average daily sales
The status of receivables of a company can be said to be under control, if the
daily sales outstanding lies within a pre-specified norm which is linked to the
credit period followed by the company. A higher daily sale outstanding indi-
cates that the collection process is slow and so the collection policy should
be made more stringent.
4. Collection Matrix
In order to analyze the behavioural changes in the payments made by the
customers, it is necessary to study the collection patterns associated closely
with the credit sales.
For example, the credit sales in different months are as follows.
20% in January, 22% in February, 25% in March, and 30% in April
By observing the collection pattern, one can make out whether the collection
is improving or is constant or is decreasing.
An advantage of this method is that we can maintain percentage of collec-
tions that can be used to be projected in monthly receipts for each budgeting
period.
1. _________is used as a marketing tool, particularly when a new prod-
uct is launched or when a company wants to push its weak product.
a. Finance
b. Credit
2. ___________depicts the age-wise distribution of accounts receivable
at any particular time.
a. Ageing schedule
b. Cost
147
WORKING CAPITAL 2.4 Cash Management
MANAGEMENT AND Cash is considered of crucial importance because it is the most liquid asset
INVESTMENT and the life blood of the firms. Since cash is the life blood of the business, it is
a decisive factor in the solvency of the company.
Difference between profit and cash
Normally, we think profits and cash is the one and the same concept. Profit
sare the excess of income over the expenditure of the companies for a year. It
includes cash and non-cash items. (Cash items like sales, interest on invest-
ments, dividend etc. and non-cash items like credit sales, excess provisions
for doubtful debts)
Cash means the cash and bank balances of the company for the particular
year given in the balance sheet. Profits of the company depict earning capac-
ity of the company and cash shows the company’s liquidity position.
Normally, cash in a narrow sense is cash and bank balances and demand de-
posits with the bank and in the broader sense it includes cash and bank bal-
ances and demand deposits with the bank plus marketable securities that can
be converted into cash.
2.4.1 Reasons for Holding Cash
Let us see why the companies hold the cash.
1. Transaction Motive
2. Precautionary Motive
3. Speculative Motive
4. Cash Flow Management
1. Transaction Motive
Since the companies enter into transactions with the other companies
and some of these transactions are cash based and rest of them are
credit based, the company has to strike abalance between cash inflow
and cash outflow. The company keeps some amount as cash to deal
with such transactions where transactions are cash based.
2. Precautionary Motive
Contingencies like sudden fire, accidents, employee strike, early pay-
ment to the creditors, mismatch between receipt and payments can
occuranytime. The company maintains some amount in the form of cash
to safeguard against such incidents.
3. Speculative Motive
Speculative motives play abig role in holding the cash by the corporate.
To take the advantage of sudden decrease in the raw material prices or
to invest in investment opportunities which are short term, the compa-
nies keep some amount of cash with them.
4. Cash Flow Management
In cyclical and seasonal industries like automobile, tea, jute there is
mismatch between cash inflow and cash outflow. These companies hold
more cash than required to safeguard against seasonal or cyclical
148
changes.
WORKING CAPITAL
2.4.2 Factors for Efficient Cash Management MANAGEMENT - II
We need to consider following factors to enhance the efficiency of cash man-
agement.
1. Immediate prepa ration of bills
2. Collection of cash and cheques.
3. Centralized purchasing system
1. Immediate prepa ration of bills
First and foremost step in efficient cash management is bridging the time
gap between the date of dispatching goods and the date of preparing the bills
and sending them to the customers. This means, it will help reduce the delay
in bill payment and will result in prompt receipt of cash.
2. Collection of cash and cheques
The company must deposit the cash and the cheques it received in the bank
on the same day. This can be done by
 Keeping a dedicated staff for such work
 The customers can make the payment directly by depositing the cash in
the company’s account.
3. Centralized purchasing system
When the company goes for centralized purchasing system, it can achieve
many advantages like the company can go for bulk purchase and can gain
discounts which will effectively reduce the cost allocations. Here, the com-
pany can reduce the cost of transportation, handling, and storage.
1. ______are the excess of income over the expenditure of the compa-
nies for a year.
a. Cash
b. Profits
2. Speculative motives play abig role in holding the cash by the
_________________
a. corporate
b. Incorporate
2.5 Let Us Sum Up
In this unit we had a very detailed discussion on the working capital manage-
ment and on the inventory management. This chapter covered the basics of
working capital management and it included areas like receivables manage-
ment, cash management and inventory management. In this unit we discussed
that companies hold inventories basically for 3 motives -Transactions motive
i.e. to ensure smooth production and sales operations, Precautionary motive
i.e. to guard against the volatility of demand and supply factors, Speculative
motive which is done to take benefit of price fluctuations.Other purposes of
149
WORKING CAPITAL holding the inventory are - To safeguard against lost sales, to gain trade dis-
MANAGEMENT AND counts, Reducing operational cost, Ensuring efficient production activities.We
INVESTMENT covered inventory management techniques like - Economic Order Quantity
(EOQ), Reorder point, and Stock Level. We price the inventories by five
methods namely - First-in-first-out (FIFO), Last-in-first-out (LIFO), Weighted
Average Cost method, Standard Price method and Replacement or Current
Price method.Purpose of the receivables include - Maximizing the sales by
selling the goods on credit rather than insisting on immediate payment of
cash. When the goods are sold on credit, higher profit margins are charged
unlike cash sales, resulting in increased profits and third being the company
will have to give better credit terms than offered by its competitors. We know
that cost of maintaining the receivables are high and that include Blockage of
additional funds, Maintenance cost, Defaulting cost, Collection cost. There
are four methods of managing the receivables. They are - Average collection
period (ACP), Ageing schedule, Days Sales Outstanding and Collection
Matrix.We saw the difference between the cash and profit concept. There are
four reasons to hold the cash - Transaction motive, Precautionary motive,
Speculative motive, Cash flow management.
So at the end of this unit the readers would have got the sufficient idea of
working capital and inventory management and various other concepts which
are considered to be very important.
2.7 Glossary
1. Working Capital Policy - Basic policy decision regarding (1) target
levels for each category of current assets and (2) how current assets
will be financed.
2.8 Assignment
What is working capital management in the context of receivables manage-
ment and cash management?
2.9 Activities
Explain inventory management techniques
2.10 Case Study
Visit a company nearest to you and find out how does the company manage
its receivables, cash and inventories?
150
2.11 Further Readings WORKING CAPITAL
1. Financial management - ICFAI. MANAGEMENT - II
2. Financial management – I. M. Pandey
3. Financial management – Khan & Jain
151
WORKING CAPITAL
MANAGEMENT AND Unit
INVESTMENT INVESTMENTS AND FUND
3
: UNIT STRUCTURE :
3.1 Introduction
3.2 Meaning of Capital Budgeting
3.2.1 Principles of Capital Budgeting
3.3 Kinds of Capital Budgeting Proposals
3.4 Kinds of Capital Budgeting Decisions
3.5 Capital Budgeting Techniques
3.6 Estimation of Cash Flow for new Projects
3.7 Sources of Long Term Funds
3.8 Let Us Sum Up
3.10 Glossary
3.11 Assignment
3.12 Activities
3.13 Case Study
 Why capital should be carefully evaluated before it is incurred ?
 The role of accounting profit in capital budgeting.
 Distinguish between cash flow and accounting profit.
 Calculate NPV and the Internal Rate of Return (IRR).
 Estimate cash flow for new projects.
3.1 Introduction
The term Capital budgeting contains the relatively scarce, non-human re-
source of production enterprise, and budgeting, indicating a detailed quanti-
fied planning which guides future activities of an enterprise towards the
achievement of its profit goals. Capital refers to total funds employed in an
enterprise as a whole.
3.2 Meaning of Capital Budgeting
The Capital fund is increased by an inward flow of cash and decreased by an
outward flow of cash and as such it is important for an enterprise to plan and
arrange cash flows properly.
Capital budgeting, then, consists in planning the development of available
152
capital for the purpose of maximizing the long-term profitability.
INVESTMENTS
Capital budgeting may be defined as the decision-making process by which a AND FUND
firm evaluates the purchase of major fixed assets, including buildings, ma-
chinery, and equipment. It deals exclusively with major investment proposals
which are essentially long-term projects and is concerned with the allocation
of firm’s scarce financial resources among the available market opportuni-
ties, a search for a new and more profitable investment proposal and the
making of an economic analysis to determine the profit potential of each
investment proposal. They are large, permanent commitments which influ-
ence its long-run flexibility and earning power.
It is a process by which available cash and credit resources are allocated
among competitive long-term investment opportunities so as to promote the
greatest profitability of company over a period of time. It refers to the total
process of generating, evaluating, selecting and following up on capital ex-
penditure alternatives.
3.2.1 Principal of Capital Budgeting
Capital expenditure decision should be taken on the basis of following fac-
tors-
 Creative search for Profitable opportunities-The first stage is the con-
ception of profit making idea. Profitable investment opportunities should
be sought to supplement existing proposals.
 Long range capital planning-A flexible programme of a company’s ex-
pected future development over a long period of time should be pre-
pared.
 Short range capital planning -This is for short period. It indicates its
sectoral demand for funds to stimulate alternative proposals before the
aggregate demand for funds is available.
 Measurement of project work-The economic worth of a project to a
company is evaluated at this stage. The project is ranked with other
projects.
 Screening and Selection-The project is examined on the basis of selec-
tion criteria, such as supply and cost of capital, expected returns, alter-
native investment opportunities etc.
 Control of authorized outlays-Outlay should be controlled in order to
avoid costly delays and cost over-runs.
 Post Mortem-The ex-post routines of a completed investment project
should be re-evaluated in order to verify their exact conformity with
exact projections.
 Forms and Procedures-These involve the prepa ration of reports nec-
essary for any capital expenditure programme.
 Economics of capital budgeting-It includes estimating the rate of re-
turn on capital expenditure. Knowledge of economic theory underly-
ing investment decisions is needed for this purpose.
153
MANAGEMENT AND 1. _______may be defined as the decision-making process by which a
INVESTMENT firm evaluates the purchase of major fixed assets, including buildings,
machinery, and equipment.
a. Capital structure
b. Capital budgeting
2. Economics of capital budgeting-It ___________ the rate of return on
capital expenditure.
a. includes estimating
b. estimates
3.3 Kinds of Capital Budgeting Proposals
 Replacement
 Expansion
 Modernization of Investment Expenditures
 Strategic Investment Proposals
 Diversification
 Research and Development
1. ____________decision includes expenses incurred on modernization
of investment expenditures on existing asset.
a. Capital structure
b. Financial budgeting
c. accounting
d. Capital budgeting
3.4 Kinds of Capital Budgeting Decisions
Capital budgeting refers to the total process of generating, evaluating, select-
ing and following upon capital expenditure alternatives. The firm allocates or
budgets financial resources to new investment proposals. Basically the firm
may be confronted with three types of capital budgeting decisions -
 Accept-reject decisions
 Mutually Exclusive Project decisions
 Capital rationing decisions.
1. The firm allocates or budgets _______to new investment proposals on
the basic of capital budgeting techniques
a. asset
b. financial resources
2. ___________refers to the total process of generating, evaluating, se-
lecting and following upon capital expenditure alternatives
a. Capital budgeting
b. Financial budgeting
154
3.5 Capital Budgeting Techniques INVESTMENTS
AND FUND
Fig 3.1 Capital Budgeting Techniques

Pay Back Method
The pay back method (PB) is the traditional method of capital budgeting. It
is the simplest and perhaps, the most widely employed quantitative method
for appraising capital expenditure decisions. This method answers the ques-
tion - How many years will it take for the cash benefits to pay the original
cost of an investment? Cash benefits here represent CFAT (cash flows after
taxes) ignoring interest payment. This method measures the number of years
required for the CFAT to pay back the original outlay required in an invest-
ment proposal.
There are two ways of calculating the PB period. The first method can be
applied when the cash flow stream is in the nature of annuity for each year of
the project’s life i.e. CFAT are uniform.
PB Period = Investment / Constant annual cash flow
The second method is used when a project’s cash flowsare not equal, but
vary from year to year. In such a situation, PB is calculated by the process of
cumulative cash flows till the time when cumulative cash flowsbecome equal
to the original investment outlay.
If the actual payback period is less than the pre-determined pay back, the
project would be accepted; if not, it would be rejected. When mutually ex-
clusive projects are under consideration, they may be ranked according to
the length of the payback period.Thus, the project having the shortest pay
back may be assigned rank one.
Example:
1. A project requires an initial investment of R 1,80,000and yield an an-
nual cash inflow of R60,000 for 8 years.
1,80,000
PB Period = = 3 years
60,000
2. A project requires an initial cash outlay of R 5,00,000/- and generates
cash inflows as under-
155
WORKING CAPITAL Year Cash Inflows
MANAGEMENT AND 1 50,000
INVESTMENT
2 1, 00,000
3 1, 25,000
4 2, 00, 000
5 50,000
6 50,000
7 50,000
8 25,000
Calculated payback period -
Calculation of payback period
Year Cash Inflows (R) Cumulative cash Inflows
1 50,000 50,000
2 1,00,000 1,50,000
3 1,25,000 2,75,,000
4 2,00,000 4,75,000
PBP Exists
5 50,000 5,25,000
6 50,000 5,75,000
7 50,000 6,25,000
8 25,000 6,50,000
upto 4th year 4,75,000 are received back. Now only R 25,000 (R 5,00,000 – R
4,25,000) are to be recoverd from 5th years. In 5th year receipt will be R 50,000.
Rs. 25,000
 = 6 months
Rs. 50,000
50,000 = 12 months
R 25,000 = (?)
PB period of project = 4.5 years i.e. 4 years and 6 months.
Advantages of Pay Back Method:-
 It is an important guide to investment policy.
 It lays a sufficient emphasis on liquidity.
 It is easy to understand, calculate and communicate.
 The method enables a firm to choose an investment which yields a quick
return on cash funds.
 It enables a firm to determine the period required to recover the origi-
nal investment with some percentage return and thus arrive at the de-
gree of risk associated with the investment.
 It is an adequate measure with every profitable investment opportunity.
156
 The method is quite the simplest of all the techniques used by the in-
INVESTMENTS
dustry.
AND FUND
 It is undoubtedly an improvement over the criteria of urgency.
 Other than its simplicity, the main advantage claimed for the payback
method is that is abuilt-in safeguard against risk.
Disadvantages:
 The method is not consistent with the objective of maximizing the mar-
ket value of firm’s share.
 It does not consider income beyond the payback period.
Average Rate of Return Method
This method is also known as Accounting Rate of Return. This method con-
siders Avegare profit and average investment which means the average an-
nual yield of the project. Under this method profit after tax and depreciation
(also called as accounting profit) of a percentage of total investment is con-
sidered.
The annual returns of a project are expressed as a percentage of the net
investment in the project. This method consists of aggregating all the earn-
ings after depreciation and dividing them by the profits in useful lifespan.
The resultant average earnings over the period is divided by the average
investment over the period. The average investment in a project is always ½
of the original investment. For calculating ARR, sometimes the value of the
initial investment is used in the place of average investment. But average
investment is more logical.
Average Annual Earnings aftertaxes & depreciation

ARR = × 100
Average Investment
Where,
Original investment
Average investment =
2
Advantages:
 It is easy to calculate because it makes use of reality available account-
ing information.
 Where a number of capital investment proposals are being considered,
a quick decision can be taken.
 If high profits are required, this is certainly a way of achieving them.
 It is also simple to understand and easy to adopt.
 It can be calculated using the accounting data.
Disadvantages:
 It does not consider the length of life of projects.
 It ignores the fact that the profits earned can be reinvested.
 It does not consider the benefits accruing to the company as a result of
sale.
157
WORKING CAPITAL  It does not take into accounting time value of money
MANAGEMENT AND  It uses the straight line method of depreciation. Once a change in method
INVESTMENT of depreciation takes place the method will not be easy to use and will
not work practically.
Example:
ABC Ltd. is considering the purchase of a machine. Two machines are avail-
able X and Y. The cost of each machine is R 60,000. Each machine has an
expected life of 5 years. Net profit before tax but after depreciation during
the expected life of the machine is given below :
Year Machine X (R) Machine Y (R)
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Total 85,000 90,000
Following the method of return on investment ascertain which of the alterna-

tives will be more profitable.The average rate of tax may be taken as 50%.
Statement of Profitability
Year Machine X (R) Machine Y (R)

Profit Tax at Profit Profit Tax at Profit
Before 50% After Tax Before 50% After
Tax (R) (R) (R) Tax (R) (R) Tax (R)
1 15,000 7,500 7,500 5,000 2,500 2,500
2 20,000 10,000 10,000 15,000 7,500 7,500
3 25,000 12,500 12,500 20,000 10,000 10,000
4 15,000 7,500 7,500 30,000 15,000 15,000
5 10,000 5,000 5,000 20,000 10,000 10,000
85,000 42,500 42,500 90,000 45,000 45,000
Average Profit 42,500 = 5 = 8,500 45,000 + 5 = 9,000

(After tax) 60,000 = 2 = 30,000 60,000 = 2 = 30,000
Investment (8,500 30,000) × 100 = 28.33% (9,000  30,000) × 100 = 30%
Rate of Return
158
Machine Y is more profitable (Note: It is presumed that net profit is arrived
INVESTMENTS
after providing for depreciation).
AND FUND
Example:
The working results of two machines are given below
Machines I (R) Machines II (R)
Cost of machines 45,000 45,000

Sales per Year 1,00,000 80,000
Total cost per year (excluding 36,000 30,000
depreciation)
Expected life 2 Years 3 Years

Which of the two should be preferred?
Solution:
Calculation of Annual Average Earnings
Machines I (R) Machines II (R)

Sales per year 1,00,000 80,000
Less: Cost per year 36,000 30,000

Profit before depreciation
64,000 50,000
Less: Depreciation 22,500 15,000

Net Profit 41,500 35,000
Annual Average 41,500 35,000

Earnings
Annual Investment 22,500 22,500

Arr = 41,500 35,000
 100  184%  100  156%
22,500 22,500
Note : Depreciation
I II
45, 000 45, 000

2 years 3 years
= R 22,500 = R 15,000
Machine I has higher ARR. Hence Machine I should be preferred.
Net Present Value (NPV) Method
The objective of the firm is to create wealth by using existing and future
resources to produce goods and services. To create wealth, inflows must
exceed the present value of all anticipated cash outflows. NPV is obtained by
discounting all cash outflows and inflows attributable to certain investment
159
WORKING CAPITAL project by a chosen percentage e.g. the entity’s weighted average cost of
MANAGEMENT AND capital. The method discounts the net cash flows from the investment by the
INVESTMENT minimum required rate of return and deducts the initial investment to give the
yield from the funds invested. If yield is positive the project is acceptable. If it
is negative the project is unable to pay for itself and is thus unacceptable.
The activity involved in calculating the present value is known as discounting
and the factors by which we have multiplied the cash flows are known as the
discount factors.
Ct
NPV  C0  (1  r )t
C1 C2 Ct
NPV  C  (1  r )1  (1  r )2 ...  (1  r )t
0
Calculation of NPV (Net Present Value)
Discount factors = l
(l + r)n
Where, ‘r’ is the rate of interest per annum
‘n’ is the number of years for which we are discounting.
Advantages
 It is based on the assumption that cash-flows and dividends determine
shareholder’s wealth
 It recognizes the time value of money.
 It considers the total benefits arising out of proposals over its life-time.
 This method of project selection is instrumental in achieving the finan-
cial objective i.e. the maximization of shareholder’s wealth
Disadvantages
 It is difficult to calculate as well as understand it as compared to ac-
counting rate of return method or PB method.
 Calculation of the desired rates of return presents serious problems.
Generally cost of capital is the basis of determining the desired rate.
The calculation of cost of capital is itself complicated. Moreover, de-
sired rates of return will vary from year to year.
 This method is an absolute measure. When two projects are being con-
sidered, this method will favour the project which has higher NPV (Net
Present Value).
 This method emphasizes the comparison of NPV and disregards the
initial investment involved. Thus, this method may not give dependable
results.
Example: 1)
A choice is to be made between two competing proposals which require an
equal investment of R50, 000 and are expected to generate net cash flows as
160
under:
INVESTMENTS
Cost of capital of the company is 10%. AND FUND
Problem
Project X (R) Project Y (R)

1st Year end 25,000 10,000
nd
2 Year end 15,000 12,000
rd
3 Year end 10,000 18,000
4th Year end Nil 25,000
5th Year end 12,000 8,000
th
6 Year end 6,000 4,000
Comparative Statement of Net Present Values Capital
PV Project X Project Y
Year Factor Cash Present Cash Present
at 10% Inflows Values Inflows Values
1 0.909 25,000 22,725 10,000 9,090
2 0.826 15,000 12,390 12,000 9,912
3 0.751 10,000 7,510 18,000 13,518
4 0.683 Nil Nil 25,000 17,075
5 0.621 12,000 7,452 8,000 4,968
6 0.564 6,000 3,384 4,000 2,256
Total Present 53,461 56,819

value Cash
Inflows
Initial 50,000 50,000

Investments
(Cash Outlay)
Net present R 3,461 R 6,819
value
Since project Y has the highest NPV (Net Present Value), Project Y should
be selected
Note : Present value of a rupee at different is available from present value
table.
Example 2
Project X initially costs R 25,000. It generates the following cash follows
161
WORKING CAPITAL
Year Cash inflows (R) Discount Factor at 10% (R)
MANAGEMENT AND
INVESTMENT 1 9,000 0.909
2 8,000 0.826
3 7,000 0.751
4 6,000 0.683
5 5,000 0.621
Taking the cut - off rate as 10%, suggests whether the project should be
accepted or not.
Solution:
Statement of Net Present Value
Year Cash P. V. Factor at Present Values of
Inflows 10% (R) Cash Inflows (R)
1 9,000 0.909 8,181

2 8,000 0.826 6,608
3 7,000 0.751 5,257
4 6,000 0.683 4,098
5 5,000 0.621 3,105
Total Present Value of 27,249
Cash Inflows
Less: Initial Outlay 25,000

NPV 2,249
The Project should be accepted since the Net Present Value (NPV) is posi-
tive.
Profitability Index Method
The profitability index (PI) is yet another method of evaluating the invest-
ment proposals. It is also known as the benefit- cost ratio (B/C). It represents
a ratio of the present value of future cost benefit at the required rate of return
to the initial cash outflow of the investment. This is similar to the NPV ap-
proach.
The PI approach measures the present value of returns per rupee invested.
Where projects with different initial investments are to be evaluated the PI
approach is the best technique to be used.
Present value of cash inflows

PI =
Present value of cash outlay
In this method, the numerator measures the benefits and the denominator
measures the costs. The project is to be accepted when the PI is greater than
1 and it will be negative when PI is less than 1.
162
The selection of the projects with the help of PI method can be affected on
INVESTMENTS
the basis of ranking. The project with the highest PI is given the first rank
AND FUND
followed by others in the descending order.
Advantages
 This method takes into consideration the time value of money as also
the total benefits spread throughout the life span of the project. It can
be employed safely as sound investment criteria.
 The PI method is abetter evaluation technique than the NPV (Net
Present Value) method in a situation of capital rationing.
Disadvantages
 The PI method is not easy to understand, and is difficult to use in
practice.
 It involves more tedious calculations than the traditional method.
Example 1)
The initial cash outlay of a project is R 1,00,000 and it generates cash inflow
of R 40,000. R30, 000, R50,000 and 20,000. Assuming 10% rate of discount,
calculate Profitability index.
Solution
Year Discount Factor at 10%

1 0.909
2 0.826
3 0.751
4 0.683
Calculation of Profitability Index

Year Cash Inflow Discount Present
at 10% (Rs.) Factor Value (Rs.)
1 40,000 0.909 36,360
2 30,000 0.826 24,780
3 50,000 0.751 37,550
4 20,000 0.683 13,600
Total PV Rs. 1,12,350
PV of cash inflowas 1,12,350

Profitability Index = = = 1.1235
Intial Cash outlay 1,00,000
Since PI is greater than 1 project should be accepted.
2) Problems
The initial outlay of the project is R1,00,000 and it generates cash inflows of
163
WORKING CAPITAL R50,000, R40,000, R30,000 and R20,000 in the years of its lifespan. You are
MANAGEMENT AND required to calculate the NPV (Net Present Value) and PI of the project as-
INVESTMENT suming 10% rate of discount.
Year Cash Inflows Discount Factor Present Values

(R) at 10%
(2 × 3) (R)
1 50,000 0.909 45,450
2 40,000 0.826 33,040
3 30,000 0.751 22,530
4 20,000 0.683 13,660
1,14,680
Less: Cash
Outlay NPV
1,00,000
NPV
14,680
Year Cash Inflows Discount Factor at 10% Present Values (R) (2x3)
(R)
1 50,000 0.909 45,450
2 40,000 0.826 33,040
3 30,000 0.751 22,530
4 20,000 0.683 13,660
1,14,680
Investments 4 0.683 and Fund
94
Working Capital Management
and Investment
Less: Cash Outlay NPV 1,00,000
14,680
PI (Gross) = 1,14,680=1.1468 PI (Net)=1.1468-1=0.1468
1,00,000
Internal Rate of Return Method (IRR)
The IRR Method is yet another discounted cash flow technique which takes
into consideration the magnitude and timing of cash flows. It is also known as
time adjusted rate of return, marginal efficiency of capital, marginal produc-
tivity of capital, and yield on investment and so on. It is employed with the
cost of investment and the annual cash inflows are known while the unknown
rate of earnings is to be ascertained. It is known as trial and error method.
The Internal Rate of Return (IRR) is that rate at which the sum of discounted
cash inflows equals the sum of discounted cash out flows. It is the rate at
which the NPV (Net Present Value) of the investment is zero. It is called
164
internal rate because it depends mainly on the outlay and proceeds associ-
INVESTMENTS
ated with the investment and not on any rate determined outside the invest-
AND FUND
ment.
Advantages
 The IRR method considers the time value of money like the NPV
method.
 It takes into consideration the cash flows over the entire lifespan of the
project.
 Business executivesand non-technical people understand the concept
of Internal Rate of Return (IRR) much better than that of NPV.
 It is consistent with the overall objective of maximizing shareholder’s
wealth.
Disadvantages
 It produces multiple rates which can be confusing.
 Selected project based on higher IRR may not be profitable.
 Unless the life of the project is accurately estimated, assessment of
cash flows cannot be correctly made.
 This method is difficult to understand as well as apply in practice be-
cause it involves complicated calculations.
 This method does not give unique answer in all situations. It yields
negative rate or multiple rate under certain circumstances.
Steps to solve problem :
(i) Assume is discount rates (a) Lower rate and (b) higher rate.
(ii) At lower rate NPV of Project should be positive
(iii) At lower rate NPV of Project should be negative.
(iv) Formula :
NPV of Lower rate
IRR = Lower rate + NPV of Lower rate - NPV of higher rate × (HR–LR)
Example:
Project X involves an initial outlay of R1, 60,000. Its lifespan is expected to
be three years. The cash streams generated by it are expected to be as fol-
lows:
Cash Inflows
Year
(R)
1 80,000
2 70,000
3 60,000
You are required to calculate the l RR
165
WORKING CAPITAL Solutions
MANAGEMENT AND
Rate of Rate of Rate of
INVESTMENT Cash Present Present Present
Year Discoun Discount Discount
Inflows Value (R) Value (R) Value (R)
t (14%) (16%) (15%)
1 80,000 0.877 70,160 0.862 68,960 0.870 69,600
2 70,000 0.770 53,900 0.743 52,010 0.756 52,920
3 60,000 0.675 40,500 0.641 38,460 0.658 39,480
Less: Initial Outlay 1,64,560 1,59,430 1,62,000
1,62,000 1,62,000 1,62,000
NPV (+) 2560 (-) 2,570 Zero
(1) Formmula :
NPV of Lower rate
IRR = Lower discount rate + NPV of Less Lower rate - NPV of higher rate
×
(Higher rate – Lower rate)
2560 (16-14) 2560

= 14 + × = 14 + × 2 = 15%.
2560 (-2570) 5100
Practical Problems
Example - A company is considering a new project for which the investment
dataare as follows:
Capital outlay R 2,00,000 Depreciation 20% p.a.
Forecasted annual income before charging depreciation but after all other
charges, are as follows:
Year R
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
4,00,000
On the basis of the available data, set out calculation, illustrating and com-
paring the following method of evaluating the return:-
a) Payback method b) Rate of return investment c) Internal rate of return.
Solution
Since there is no tax, the annual income before depreciation and after other
charges is equivalent to cash flows (CF)
166
a) Capital outlay of R 2,00,000 is recovered in the first two years, R 1,00,000
INVESTMENTS
(year) + R1,00,000 (year2), therefore the payback period is two years.
AND FUND
B) Rate of return on original investment:
Year CF (R) Depreciation Net Income

(R) (R)
1 1,00,000 40,000 60,000
2 1,00,000 40,000 60,000
3 80,000 40,000 40,000
4 80,000 40,000 40,000
5 40,000 40,000 --------
2,00,000
Average Income = R 2,00,000/5 = R 40,000
Average Income Rs. 40,000

Rate of return = × 100 = 100 = 20%
Original investment Rs. 2,00,000
C) Calculation of IRR
Total CF Rs. 4,00,000

Average CF = = = 80,000
No. of Year 5
Cash out Flows Rs. 2,00,000

PB value = = = 2 years.
Average CF Rs. 1,00,000
Total PV
Year CF (R) PVT at
(R)
30% 34% 30% 34%

1 1,00,000 0.769 0.746 76,900 76,600
2 1,00,000 0.592 0.557 59,200 55,700
3 80,000 0.455 0.416 36,400 33,280
4 80,000 0.350 0.310 28,000 24,800
5 40,000 0.269 0.232 10,760 9,280
2,11,260 1,97,660
The IRR (Internal Rate of Return) of a project is the rate of discount at
which the NPV (Net Present Value) is 0.
NPV of Lower rate
IQR = Lower rate + NPV of Lower rate - NPV of higher rate × (HR–LR)
11,260
= 30 + × (34 – 30)
11,260 - (-2,340)
167
WORKING CAPITAL 11,260
MANAGEMENT AND = 30 + ×4
13,600
INVESTMENT
= 30 + 3.31
= 33.31 %
Example -
The cash flows from two mutually exclusive Projects A and B are as under:
Years Project A Project B

0 R –22,000 R –27,000
(1-7 Annual) 6,000 7,000
Project life 7 Years 7 Years
i) Calculate NPV of the proposals at different discount rates of 15%, 16%,

17%, 18%, 19% and 20% ii) Advise on the project on the basis of the Internal
Rate of Return (IRR) method.
Solution:
Computation of Present Value of cash inflows of different Projects
Cash Flow (R) P.V. Cash Flow (R)

Dis. Rate PVAF* Project
Project A Project B Project A
B
15% 6,000 7,000 4.160 24,960 29,120

16% 6,000 7,000 4.040 24,240 28,280
17% 6,000 7,000 3.922 23,532 27,454

18% 6,000 7,000 3.812 22,872 26,684
19% 6,000 7,000 3.706 22,235 25,942
20% 6,000 7,000 3.605 21,630 25,235
*This value is available from present value annnity factor. This can be calcu-
lated as follows also, It is calculated for 15% like wise for rest rates also can
be calculated.
168
Project A :
INVESTMENTS
Year CIF DF @ 15% PV AND FUND
1 6000 .879 5220
2 6000 .756 4536
3 6000 .658 3948
4 6000 .572 3432
5 6000 .497 2982
6 6000 .432 2592
7 6000 .375 2250
Annuity Value 4.16 24,960
Calcutation of IRR
Dis. PV of inflows
PV of inflows (A) NPV (A) NPV (B)
Rate (B)
15% R 24,960 R 2,960 29,120 R 2,120
16% 24,240 2,240 28,280 1,280
17% 23,532 1,532 27,454 454

18% 22,872 872 26,684 (-) 216
19% 22,235 235 25,942 (-) 1,058

20% 21,630 -370 25,235 (-) 1,765
Calculation of the Internal Rate of Return (IRR)

Project A: Since outflow of R 22,000 is falling between R 22,235 and R
21,630, the IRR must be between 19% to 20%. So, interpolating the differ-
ence of R 605 between 19% and 20%, the IRR comes to 19.39%.
235 235
= 19 + × (20 – 19) = 19 + × 1 = 19.39%
235-(-370) 605
Project B: Since outflow of R 27,000 is falling between R27,454 and R26,684,
the IRR must be between 17% to 18%. So, interpolating the difference of R
770 between 17% and 18%, the IRR comes to 17.68%
454 454
= 17 + × (18 – 17) = 17 + × 1 = 17.68%
454 - (-216) 670
Conclusion:
As per the NPV technique, the Project is acceptable even if the discount rate
is as high as 19% whereas, the project B becomes invariable at 18%. As per
IRR (Internal Rate of Return) technique, the project A is acceptable and is
having an IRR of 19.39% against the IRR of 17.68% of Project B
169
MANAGEMENT AND 1. The ___________of Return (IRR) is that rate at which the sum of dis-
INVESTMENT counted cash inflows equals the sum of discounted cash out flows
a. Internal Rate
b. External Rate
2. The objective of the firm is to ___________by using existing and fu-
ture resources to produce goods and services.
a. create Health
b. create wealth
3.6 Estimation of Cash Flow for New Project
Evaluation of a project should rather be based on cash flows as distinct from
accounting profits.
Accounting profits are useful only for external reporting purposes and by
themselves cannot be used for the purpose of capital budgeting decisions.
Accounting profits are capable of distortion because of possible bias of indi-
vidual accountants. Different methods of providing depreciation and valuing
closing stocks can lead to different accounting figures. On the other hand,
cash flowsare totally independent of different methods of accounting for de-
preciation and stocks. Properly calculated cash flows cannot be challenged
by anyone.
Accountants do start with rupee coming in and rupee going out when they
write cash book. But when calculating accounting income they carry out
certain adjustments for depreciation, accruals and stock valuations. It is not
always easy to convert the customary accounting profits back into actual
cash flows but this has to be done.
We had seen earlier that cash flow = PAT + DEP but it is not always that
simple in actual practice. Reputed text books have highlighted some basic
principles of cash flows which are summed up below:
 Cash flows should be estimated on an incremental basis. A true worth
of a project depends only on additional cash flows that can be gener-
ated if a project is accepted.
 It is necessary to take into consideration all incidental effects of a project
on remainder of the business. Introduction of a new product may affect
revenue of an existing product and therefore we must take into consid-
eration this fact which is not normally recordable in accounting.
 Sunk costs should be ignored because they do not affect outflow of
cash now. Whether we accept a project or reject it, sunk costs do not
change and should therefore be ignored. For example, if we construct a
factory on a piece of land, which was earlier acquired for another project
but not actually put to use, is a sunk cost. There is no outflow if the
same piece of land is now used for a new project.
 Opportunity costs cannot be ignored. This was hinted at point number
two above. This can be stretched a little further. Suppose a new project
170
starts on a piece of land, which is not now acquired. However, if it is
INVESTMENTS
decided to sell the land for a sum and if it is not used for the new
AND FUND
project then there is an opportunity cost or an implied outflow. Sale
proceeds of the land will have to be sacrificed to implement the new
project.
 Any new project will always entail an additional investment in short
term assets like cash, debtors and stocks. The additional investment to
some extent is reduced to the extent to which short-term liabilities like
creditors increase. The increase in net working capital requirements
becomes an outflow and when the project finally ends, investment in
working capital can be recovered either fully or partly. This will be-
come an inflow.
 Cash flows should always be estimated on an after tax basis.
Inflation, if persisting should always be treated on a consistent basis. This
requires conversion of nominal cash flows into real cash flows.
1. Any ___________will always entail an additional investment in short
term assets like cash, debtors and stocks.
a. investment
b. new project
3.7 Sources of Long Term Funds
Tabular Presentation of Sources of Long Term Funds for capital
dudgeting
Fig 3.2 Source of long term fund

Brief Characteristics of the above Diagram:
 Interest on debentures or Term loans has to be paid whether there is
any profit or not.
 Interest is a tax-deductible expense
 Dividend on preference shares is paid at fixed rate only if there is ad-
equate profit after tax. If preference shares are cumulative then the
dividends not paid will accumulate and will become payable in future.
 On equity shares, there is no fixed rate of dividend. Dividend may be
skipped if profits are inadequate. Dividend may be very high if there is
171
WORKING CAPITAL abumper profit. Dividend can only be paid after preference dividend
MANAGEMENT AND (including arrears if any) are paid and transfer to General Reserve De-
INVESTMENT benture and Redemption Reserve are made.
1. _________on debentures or Term loans has to be paid whether there is
any profit or not.
a. Payment
b. Dividend
c. Interest
3.8 Let Us Sum Up
In this unit we had a very detailed discussion on the Capital budgeting tech-
niques which are considered to be a very important tool into the hands of an
investor to know the feasibility of investment in an organisaition.
Here we studied that based on cash flows are more realistic than these based
on accounting profits. NPV approach is considered theoretically superior to
the Internal Rate of Return (IRR) approach.We further studied that the term
Capital budgeting contains the relatively scarce, non-human resource of pro-
duction enterprise, and budgeting, indicating a detailed quantified planning
which guides future activities of an enterprise towards the achievement of its
profit goals. Capital expenditure decisions are taken considering the points
like -Creative search for Profitable opportunities, Long range capital plan-
ning, Short range capital planning, Measurement of project work, Screening
and Selection, Control of authorized outlays, Post Mortem, Forms and Pro-
cedures and Economic of capital budgeting.We understood the three differ-
ent kinds of capital budgeting proposals like – Replacement, Expansion, Mod-
ernization of Investment Expenditures, Strategic Investment Proposals, Di-
versification, and Research and Development.In this unit we covered differ-
ent capital budgeting decisions that include- Accept-reject decisions, Mutu-
ally Exclusive Project decisions, Capital rationing decisions. There are differ-
ent capitalbudgeting techniques which we studied in this chapter - Pay Back
Method, Average Rate Of Return Method, Net Present Value (NPV) Method,
Profitability Index Method, Internal Rate of Return Method (IRR). We also
covered practical problems to understand capital budgeting decisions better.
So this unit is going to be of great help for the readers in understanding the
concepts of various capital budgeting techniques and various other concepts
associated to it.
Answers: (1-d)
172
INVESTMENTS
Answers: (1-a), (2-b) AND FUND
Answers: (1-b)
Answers: (1-c)
3.10 Glossary
1. Capital Budgeting - The process of planning expenditures on assets
whose cash flows are expected to extend beyond one year.
3.11 Assignment
Explain in detail different capital budgeting techniques
3.12 Activities
Which are the sources of long-term funds?
3.13 Case Study
How are the capital budgeting decisions helpful in selection of any project?
Explain with suitable example.
1. Fundamental of financial Management...... Dr. Prasanna. Chandra.
2. Financial Management........ P.V. Kulkami.
3. Financial Management ........Khan and Jain.
4. Financial Management....... Dr. Mahesh Kulkarni.
5. Financial Management...... Ravi Kishore.
173
WORKING CAPITAL BLOCK SUMMARY
MANAGEMENT AND
In this block we had a very detailed study on working capital, inventory man-
INVESTMENT
agement and on various capital budgeting techniques.
In unit 1 and 2 we discussed about the working capital. These units have
discussed in detail about working capital. It discusses about Meaning and
Definition of Working Capital, Types of Working Capital, Factors Affecting
Working Capital / Determinants of Working Capital, Operating Working Capi-
tal Cycle, Working Capital Requirements, Estimating Working Capital Needs
and Financing Current Assets, Further unit 2 discusses about in detail about
Inventory Management, Purpose of holding inventories, Types of Invento-
ries, Inventory Management Techniques, Pricing of inventories, Receivables
Management, Purpose of receivables, Cost of maintaining receivables, Moni-
toring Receivable, Cash Management, Reasons for holding cash, Factors for
efficient cash management. Lastly in unit 3rd we discussed about the capital
budgeting and its importance in a organisation it discusses about Capital Bud-
geting, Principles of Capital Budgeting, Kinds of Capital Budgeting Propos-
als, Kinds of Capital Budgeting Decisions, Capital Budgeting Techniques,
Estimation of Cash flow for new Projects, Sources of long Term Funds.
So this block is going to help a lot the readers in explaining the other set of
few very important topics of financial management.
174
BLOCK ASSIGNMENT
1. Importance of capital budgeting.
2. Superiority of cash flow concept over accounting profit concept.
3. Comparison of NPV and the Internal Rate of Return (IRR).
4. Purposes of holding the inventories.
5. Types of inventories.
6. Economic Order Quantity (EOQ).
7. Working Capital required for different businesses.
8. Disadvantages of inadequate working capital.
1. Discuss the various ways through which the working capital cycle can
be shortening.
2. What are the factors for efficient cash management?
3. Explain the role of capital budgeting techniques in investment making
decisions.
4. What are types of Capital Structure?
5. What are the techniques of Inventory Management?
6. Discuss cost of maintaining receivables.
175
WORKING CAPITAL Enrolment No.:
MANAGEMENT AND
INVESTMENT 1. How many hours did you need for studying the units?
Unit No. 1 2 3
Nos of Hrs
2. Please give your reactions to the following items based on your reading
of the block:

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
176
Ambedkar
OpenUniversity
BLOCK-4 INVESTMENT ANALYSIS AND FINAN-

CIAL PLANNING
UNIT 1
INVESTMENT ANALYSIS
UNIT 2
FINANCIAL PLANNING- I
UNIT 3
FINANCIAL PLANNING- II
UNIT 4
DIVIDEND POLICIES
177
INVESTMENT BLOCK 4 : INVESTMENT ANALYSIS AND FINANCIAL
ANALYSIS AND PLANNING
FINANCIAL PLANNING
Block Introduction
In this block we shall focus on the investment analysis and various other financial
planning decisions.
This block is divided into three units where unit 1st discusses about the topic
investment analysis in details whereas unit 2nd& 3rd deals with financial planning.
Here in unit 1 we have discussed about Investment and Financing Decisions, Com-
ponents of cash flows, Complex Investment Decisions
Unit 2 discusses about the following topics such as, Advantages of financial plan-
ning, Need for Financial Planning, Steps in Financial planning, Types of Financial
planning, Scope of Financial planning .In unit 3Derivatives, Future Contract, For-
ward Contacts, Options, Swaps, Difference between Forward Contract and fu-
ture contract, Financial Planning and Preparation of Financial Plan after EFR Policy
is Determined. Unit 4 is prepared for dividend and dividend policies, where forms,
legal provisions, types of policies are discussed.
This block will certainly help the readers in understanding other few very impor-
tant concept of finance.
Block Objective
After learning this block, you will be able to understand :
 Investment and financing decisions.
 Distinguish between free cash flow and terminal cash flow.
 Arrive at net working capital.
 Explain financial planning.
 The financial planning process.
 Reason why financial planning is necessary.
Block Structure
Unit 1: Investment Analysis

Unit 2: Financial Planning- I
Unit 3: Financial Planning-II
Unit 4: Dividend Policies
178
Unit INVESTMENT ANALYSIS
1
: UNIT STRUCTURE :
1.1 Introduction
1.2 Investment and Financing Decisions
1.3 Components of Cash Flows
1.4 Complex Investment Decisions
1.5 Let Us Sum Up
1.7 Glossary
1.8 Assignment
1.9 Activities
1.10 Case Study
 Investment and financing decisions.
 The components of cash flow.
 Make complex investment decisions.
 Distinguish between free cash flow and terminal cash flow.
 Arrive at net working capital.
1.1 Introduction
The investment decisions for any firm should be based on Net Present Value
(NPV) rule for which we need to discount the cash flows. Estimation of cash
flows is an important step in investment analysis. A fair amount of efforts in terms
of time and money should be invested by management of a company in obtaining
accurate cash flow estimates. The cash flows are estimated by the financial man-
ager based on the information provided by the experts of various departments
like production, marketing, accounting, economics etc. and he is also responsible
for checking the relevance and accuracy of this information.
1.2 Investment and Financing Decisions
An investment may be financed by a firm either by debt or equity, or partly by
equity and partly by debt. However, it should be noted that any earnings or pro-
ceeds from debt or equity is not treated as investment’s inflows. Likewise, the
payments of principal, interest, dividends etc are not considered as investment’s
outflows and hence are not taken into account while computing investment’s net
cash flows of the company.
179
INVESTMENT Debt and equity required to finance a firm’s investment is provided by creditors
ANALYSIS AND and shareholders' respectively. So, they expect the rate of return based on the
FINANCIAL PLANNING amount of risk they take. Creditors get the returns in terms of fixed payments
whereas the cash flows that remain after the other payments are made is passed
on to the shareholders. Clearly, the risk taken by shareholders is more than that of
the creditors and so, the rate of return expected by the shareholders is more than
that of creditors. Also, the interest paid to the creditors is tax deductible whereas
the dividends paid are not. As a result, the after-tax cost of debt is less than that of
the rate of interest. This after-tax weighted average cost of equity and debt is the
discount rate which indicates the expected payments to be made to the creditors
and the expected dividends to be given to the shareholders. By deducting the
weighted average cost of debt and equity from investment’s cash flows, we ensure
that the cash flows yielded from investments are sufficient enough to pay interests
to the creditors and dividends to the shareholders. Any residual cash after servic-
ing the equity and debt capital adds directly to the wealth of shareholders.
1. _________and equity required to finance a firm’s investment is provided
by creditors and shareholders' respectively.
a. Finance
b. Capital
c. Debt
2. An ___________may be financed by a firm either by debt or equity, or
partly by
a. equity and partly by debt
b. Investment
3. As a result, the ___________cost of debt is less than that of the rate of
interest.
a. after-tax
b. Before-tax
4. Any residual cash after servicing the equity and debt capital adds directly to
the ____________of shareholders.
a. Health
b. wealth
1.3 Components of Cash Flows
The three components of a typical cash flow are
1. Initial Investment
2. Annual net cash flows
3. Terminal cash flows
1. Initial Investment
The net cash expenditure made by the company during the period in which an
asset is purchased by a company is called its initial investment. The gross expen-
diture or the asset’s original value comprises of accessories as well as spare parts
180
and also the installation charges form the major chunk of the initial investment.
INVESTMENT
Original value is considered for the calculation of annual depreciation. The differ-
ANALYSIS
ence between the original value and depreciation forms the book value of the
asset. Also, if the assets are purchased with the aim of increasing revenues, then
investment in net working capital will also be required. So, the initial investment is
the sum of gross investment and investment in working capital.
Also, in case old assets are sold to buy new ones, then the cash obtained by
selling the old assets should also be subtracted to obtain the initial investment
figure.
Initial investment also include miscellaneous expenses such as amount spent on
electrification, water supply as well as expenses on preliminary and pre-operative
activities (that must be completed before the company’s actual work stars) like
promotional expenses, brokerage or commission if any etc.
Let us take an example of a manufacturing company, say, ABC Pvt. Ltd. Suppos-
ing the project requires land and development of site for building the factory, the
initial investments of the company would be as follows:
(R Lakh)
Property and Site Development 70
Building Factory 900
Plant and Machinery 3630
Erection Expenses 300
Miscellaneous Expenditure 250
Preliminary and pre-operative expenses 100
Contingency 300
5550
Net Working Capital 500
Total Initial Investment 6050
1. Net Cash Flows
Once the initial cash outlay has been done, the investments should start generating
cash flows. Estimation of cash flows should always be carried on after-tax basis.
Net cash flow (NCF) of a company is nothing but the difference between receipts
of cash and payment of cash and is inclusive of taxes. Though NCF primarily
consists of the annual cash flows that occur from the investment operations, any
changes in net working capital as well as capital expenditures may also affect it.
To understand NCF in more detail, let us take a simple case where in cash flows
occur only from operations. Supposing that all sales i.e. revenues are generated in
cash and payment of all expenses is also made in cash, then NCF will be defined
as
Net cash flow = Cash Revenues – Cash Expenses = Cash Profit – Tax
Note that taxes are deducted for computing NCF. The calculation of taxes is
done on the basis of accounting profit in which depreciation is considered as
deductible expense.
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INVESTMENT Depreciation and Taxes
ANALYSIS AND Any non-cash item is known as depreciation and needs to be considered in com-
FINANCIAL PLANNING putation of NCF i.e. after-tax cash flow. It is an allocation of asset cost. It does
not require any cash outflows and involves an accounting entry.
Calculation of depreciation is done as per income tax rules and is considered as
deductible expense for tax calculation. Since it decreases the tax liability of a firm,
it impacts the cash flows indirectly. The outflow of cash for the saved taxes is in
fact the cash inflow and the saving that occurs due to depreciation is called depre-
ciation tax shield.
Net working Capital
The cash receipts and payments may differ due to changes in working capital
elements like inventories, receivables and payables. For better understanding, let
us consider the following scenarios:
 Change in receivable: The payments delayed by the customers will lead
to increased receivables. Since the revenues are mostly generated through
cash sales, the cash inflows will be overstated. Hence, actual cash receipts
should be computed by subtracting (in case of increased receivables) from
or by adding (in case of decreased receivables) to the expenses.
 Change in inventory: The Company may make payments in terms of
cash for raw material and production of output that is unsold. Cash pay-
ments made for unsold material is not considered as an expense resulting in
understating the actual cash payments. Hence, computation of actual cash
payments should be done by adding (increased inventory) to or subtracting
(decreased inventory) from the expenses.
 Change in payable: The delay made by the firm in payment for materials
and sales would lead to increased account payables. And since account
payables are considered as expenses, they lead to overstating actual cash
payments. Hence, actual cash payments should be computed by subtracting
(in case of increased account payables) from or by adding (in case of de-
creased account payables) to the expenses.
Thus, it is evident that the changes in the elements of working capital should be
considered while calculating the net cash inflow. Now, here, instead of adjusting
individual components of working capital, simply the change in net working capital
can be adjusted. i.e. we can simply adjust the difference between change in cur-
rent assets and that in current liabilities.
Free Cash Flows
In the life-cycle of an investment project, reinvestment of cash flows might be
need in addition to the initial investments. This additional capital expenditure causes
the net cash outflow to decrease.
The free cash flow is defined as
Free cash flow = after-tax operating income + depreciation – net working capital
– capital expenditure.
In short, the free cash flow is nothing but the cash flow which is available to serve
both the lenders (creditors) as well as owners (share holders) who have provided
182
funds for financing investments. Free cash flow should be deducted from an
INVESTMENT
investment’s NPV. (Net Present Value)
ANALYSIS
2. Terminal Cash Flows
Salvage Value (SV)
The market value of an investment at the time of its sale is called its salvage value
and is a typical example of terminal cash flows. In this, the cash earnings or pro-
ceeds obtained from the sales of the assets is considered as cash inflow in the
terminal or last year. According to the current taxation law in India, there is no tax
liability on the sale of an asset.
In case of replacement of an existing asset, the current cash inflow will be in-
creased by its salvage value or the initial cash outlay of the new asset will be
decreased.
Following are the effects of salvage values of new and existing assets:
 The cash inflow in the terminal period of the new asset will be increased by
the salvage value of the new asset.
 The initial outlay of the new asset will be reducedby the salvage value of the
existing asset.
 The cash flow of the new investment will be reduced at the terminal period
by the salvage value of an existing asset at the end of its normal life.
Release of Net Working Capital
Apart from the salvage value, the release of net working capital may also be
included in terminal cost flows. It can be assumed that the funds involved in the
net working capital at the initial stages of investment would be eventually released
at time of termination of the investment. The net working capital may keep chang-
ing during the life of the investment and such changes in working capital should
definitely be considered during computation of annual net cash flows. Increased
net working capital indicates cash outflow while decreased net working capital
indicates cash inflow.
1. The net cash expenditure made by the company during the period in which
an asset is purchased by a company is called its ___________
a. Investment
b. initial investment
c. final investment
2. Original value is considered for the calculation of ___________deprecia-
tion
a. annual
b. Half yearly
3. The payments delayed by the customers willlead to ______________
receivables.
a. increased
b. Decreased
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INVESTMENT 4. The delay made by the firm in payment for materials and sales would lead to
ANALYSIS AND increased ___________payables.
FINANCIAL PLANNING a. Cash account
b. account
5. The ____________value of an investment at the time of its sale is called its
salvage value and is a typical example of terminal cash flows.
a. Home
b. market
1.4 Complex Investment Decisions
Many-a-times a company comes across complex investment situations and need
to choose one of the several alternatives. In such situations, the usage of NPV can
be extended to handle such complex investment decisions.
Existing asset replacement
The decisions to replace an existing asset must be monitored by necessity and
economic considerations. An existing asset must be replaced when there is avail-
ability of more economic alternative.
Normally, many companies approve new machinery only when the existing one
refuses to perform well. In other words, they follow a simple norm of replacing the
machinery only when the old one is totally out-of-service and has gone beyond
repair.
Cearly, it’s not the firm who decides when to replace, but the machinery decides
for them and so is extremely incorrect and wrong policy of replacement.
Based on the economic consideration, management should decide when to re-
place.
An economic analysis may tell the company to replace a machine say after 5
years. But, if the company replaces the machine say after 15 years when it has
gone beyond repair, then the company not only incurs extra costs but also loses
extra profit for 10 years.
Investment decisions under inflation
For the prudent investment decisions, it is always wise to assume inflation for all
the practical investment purposes. Inflation should be considered while estimating
cash flows and discount rates.
Since the investment decisions are taken for a long term and in India (being a
developing country) the two digit inflation number is common and hence inflation
should be factored in the decisions related to long term investments.
Inflation has adverse effect on the working capital. Increasing costs like raw ma-
terial, more investment is required for raw materials and receivables.
A wise investment policy takes into account the rising prices (inflation) and this
should be considered while taking capital budgeting decisions.
Investment decisions using capital rationing
Due to limited financial resources, the companies have to select profitable projects
from the various choices available.
184
There are 2 types of capital rationing:
INVESTMENT
1. Internal capital rationing ANALYSIS
2. External capital rationing
1. Internal capital rationing : Under this rationing profitable allocation of
funds is done. In case of shortage of funds selection of projects is done on
the basis of profitability of respective project.
Example 1:
Assume the amount provided for investment is limited to 50,00,000. Determine
selection of projects.
Investment Total Net Present

Project
(Amount) Investment Value
Capital A 20,000,000 4,000,000

Rationing B 20,000,000 3,800,000
Solution
C 10,000,000 50,000,000 1,500,000
1,000,000
Best Solution D 10,000,000
400,000
E 8,000,000 68,000,000
300,000
F 8,000,000
Under capital rationing, only projects A through C calling for 50,000,000 invest-
ment although projects D and E have positive net present value they will not be
accepted.
Example 2 :
Pro ject I. (milss) NPV PI Rank

A 500 110 0.22 1
B 150 -7.5 -0.05 6
C 350 70 0.20 2
D 450 81 0.18 4
E 200 38 0.19 3
F 400 20 0.05 5
In case the cash available for capital investment is 1,100m, the projects A, C and
E will be selected.
Exhibit – Capital Rationing
Source – Financial analysis revised, cbdd.wsu.edu
2. External capital rationing
External capital rationing is all about mismatches in capital markets. That means
there are companies which are dependant heavily on debt financing and so they
185
INVESTMENT fear losing the control if they go for equity financing. In this case, there are limited
ANALYSIS AND choices available for the company in selecting the projects.
FINANCIAL PLANNING There are companies in the area of biotechnology, gaming industry, nano technol-
ogy where the companies are upbeat about the profitability and sustainability of
the projects. But the investors think exactly opposite and so, it would be difficult
for the company to raise the equity capital.
Do companies face capital rationing problem in India'
 In a study of Indian Companies, it is revealed that most companies do not
reject projects on account of capital shortage. They face the problem of
shortage of funds due to the management’s desire to limit capital expendi-
tures to internally generated funds or the reluctance to raise capital from
outside.
 Most companies do not use mathematical approach to select projects un-
der capital following. The basis to choose projects under capital rationing
are :
o Profitability
o Priorities set by management
o Experience
 Some companies satisfy the criteria of profitability and strategic consider-
ations for allocating limited funds.
Generally companies do not reject profitable projects under capital rationing; they
postpone then till funds become available in future.
1. ____________means there are companies which are dependant heavily
on debt financing and so they fear losing the control if they go for equity
financing.
a. External capital rationing
b. Internal capital rationing
2. An economic analysis may tell the company to replace a machine say after
__________ years.
a. 1
b. 5
3. A wise investment policy takes into account the ____________(inflation)
and this should be considered while taking capital budgeting decisions.
a. rising prices
b. Discount Prices
4. ________________has adverse effect on the working capital. Increasing
costs like raw material, more investment is required for raw materials and
receivables.
a. compression
b. Inflation
186
5. Normally, many companies approve new machinery only when the existing
INVESTMENT
one ____________to perform well.
ANALYSIS
a. Refuses
b. Uses
1.5 Let Us Sum Up
In this unit we had a very detailed explanation on few of the very crucial aspects
of financial and investment decisions.
Here we studied about the three important cash flows - Initial Investment, Annual
net cash flows And Terminal Cash Flows. Here we even studied about the net
cash expenditure made by the company during the period in which an asset is
purchased by a company is called its initial investment. We also studied the equa-
tion Net cash flow = Revenues – Expenses – Tax. Depreciation is non cash
expenditure and needs to be considered for the part of net cash flow. In this unit
we even studied and learned the equation of free cash flow that is
Free cash flow = after-tax operating income + depreciation – net working capital
– capital expenditure; which is important for capital investments. Not only this we
even studied about complex investment decisions like Existing asset replacement,
Investment decisions under inflation, Investment decisions using capital rationing
(which includes internal and external rationing) are the part and parcel of today’s
financial management and it is imperative for the management student to study all
these techniques to arrive at the decision.
So this block is going to be of great help for all the readers in understanding few
of the very important concepts.
1.6 Answer for Check Your Progress
Answers: (1-c), (2-b), (3-a), (4-b)
Answers: (1-b), (2-a), (3-a), (4-b), (5-b)
Answers: (1-a), (2-b), (3-a), (4-b), (5-a)
1.7 Glossary
1. Yield to Maturity (YTM) - The rate of return earned on abond if it is held
to maturity.
1.8 Assignment
Explain the three components of the typical cash flow.
1.9 Activities
Describe the complex investment decisions.
1.10 Case Study
Read the annual report of a public limited company and study its cash flow state-
ment and note your observations.
187
INVESTMENT 1.11 Further Readings
ANALYSIS AND
1. Financial management- ICFAI.
FINANCIAL PLANNING
2. Financial management – I.M.Pandey.
3. Financial management – G. Sudarshan Reddy.
188
Unit FINANCIAL PLANNING- I
2
: UNIT STRUCTURE :
2.1 Introduction
2.2 Financial Planning
2.2.1 Advantages of Financial Planning
2.2.2 Need for Financial Planning
2.2.3 Steps in Financial Planning
2.2.4 Types of Financial Planning
2.2.5 Scope of Financial Planning
2.3 Let Us Sum Up
2.5 Glossary
2.6 Assignment
2.7 Activities
2.8 Case Study
 Explain financial planning.
 Realize the importance of financial planning.
 Discuss financial planning process.
 Describe the scope of financial planning.
 Reason why financial planning is necessary
2.1 Introduction
Today, everybody should have his or her financial plan which will give a road map
for the secure future.
According to McGee Financial, Financial Planning is “a process of money man-
agement that may include any or all of several strategies, including budgeting, tax
planning, insurance, retirement and estate planning, and investment strategies. In
effective financial planning, all elements are coordinated with the aim of building,
protecting, and maximizing net worth”.
The derivatives are most modern financial instruments in hedging risk. The indi-
viduals and firms who wish to avoid or reduce risk can deal with the others who
are willing to accept the risk for a price. A common place where such transactions
take place is called the ‘derivative market’.
189
INVESTMENT 2.2 Financial Planning
ANALYSIS AND
2.2.1 Advantages of Financial Planning
FINANCIAL PLANNING
1. Upgraded living
2. Money management
3. Consumption
4. Securing future
5. Building wealth
1. Upgraded living: A person can maintain income and expenditure if he knows
his financial plan. Due to increase in income and consumption pattern, the
standard of living is increasing.
2. Money management: Any income can be either saved for the future pur-
pose or consumed for the current needs financial planning helps in guiding
the person when to invest and when to consume.
3. Consumption: Consumption includes spending money on the basic neces-
sities like food, shelter, and clothing. It also includes buying luxury and semi-
luxury products. Normally, the average propensity to consume (the aver-
age inclination of an individual to spend rupee of income on the current
needs than to save for the future needs) decreases when the incom in-
creases. This results in increased saving and so, financial planning helps the
person in chalking out the plans for the future.
4. Securing Future: As we have seen in the above point that the propensity
to consume decreases when the income increases resulting into increased
savings. This increased saving is invested in different financial and real as-
sets. The idea is to give higher returns on these investments to safeguard
from increasing prices (inflation) and from rainy days.
5. Building Wealth: Financial planning helps a person to create a plan for the
future by investing in assets and keeping the current income intact. There
are many luxurious products like car, which, in long term may not give any
returns; however, it provides convenience to the person. There is another
asset like real estate which gives higher returns to the person by capital
appreciation.
By having the right mix of such assets, an individual can build the wealth
over time with the help of proper financial planning.
2.2.2 Need for Financial Planning
Every individual is different in his educational background, age, gender, attitude,
values, and basic needs. Needs can be different based on the above factors.
190
FINANCIAL
PLANNING- I
Fig 2.1 Investment Planning

 Real estate Planning
 Credit management
 Tax management
 Managing cash and savings
 Health and life insurance
 Investing in equities and fixed income securities
 Investment in mutual funds
 Contingencies
 Retirement planning
 Marriage
 Buying luxurious and domestic products
2.2.3 Steps in (Process of ) Financial Planning
Any financial planning process should be systematic, result-oriented and easy to
follow.
Following are the steps in financial planning:
Fig 2.2 Steps in Financial Planning

191
INVESTMENT  The first important step in financial planning is to have a clear picture of your
ANALYSIS AND goals and finalize those goals. Factors like expected age of retirement, in-
FINANCIAL PLANNING come expected after retirement, amount of income you would like to keep
for your surviving better half etc. can help you define your goals more clearly.
 Second step involves gathering as much information as possible. The infor-
mation should be pertaining to insurance policies, tax returns, wills, trusts
etc. The more information, the better will be your financial plan.
 Once you have adequate information, explore and process that informa-
tion. Appropriate advisors may be consulted for the same.
 Adopting a good all-inclusive financial plan can help you meet your goals
more easily as it provides you with appropriate strategies and examples.
 Once the plan has been decided, next important step is to execute that plan.
Plan can be executed by using the strategies which you are comfortable
with.
 Finally, the plan must be monitored and altered periodically with the chang-
ing conditions.
2.2.4 Types of Planning
Following are the different types of planning according to his or her requirement at
the different stages of life.
 Asset acquisition planning
 Liability and insurance planning
 Savings and investment planning
 Employee benefit planning
 Tax planning
 Retirement and estate planning
2.2.5 Scope of Financial Planning
Following are the areas that come under scope of financial planning:
 Central and state government
 Tax policies
 Regulatory environment
 Businesses
 Consumer preference
 Macroeconomic factors
 Business cycles
 Change in prices and interest rates
1. _________includes spending money on the basic necessities like food, shel-
ter, and clothing.
a. Saving
b. Investment c. Consumption
192
2. Any ______________process should be systematic, result-oriented and
FINANCIAL
easy to follow.
PLANNING- I
a. Marketing planning
b. financial planning
3. ______________planning helps a person to create a plan for the future by
investing in assets and keeping the current income intact
a. Financial
b. Marketing
4. A person can maintain _________________if he knows his financial plan.
a. Expenditure
b. income and expenditure
5. Which of the following does not comes under the scope of Financial
Planning.
a. Tax policies b. Business
c. Central govt d. schools
2.3 Let Us Sum Up
In this unit we discussed about financial planning. We discussed that it is a process
of money management that may include any or all of several strategies, including
budgeting, tax planning, insurance, retirement and estate planning, and investment
strategies. In effective financial planning, all elements are coordinated with the aim
of building, protecting, and maximizing net worth.
We studied the various advantages of financial planning.The benefits are Up-
graded living, Money management, Consumption, Securing future and Building
wealth among others. Financial planning is more than money management; it is all
about managing the current needs and to be prepared for the future needs and the
contingencies as well. An individual needs to do financial planning mainly for the
reasons like - Real estate Planning, Credit management, Tax management, Man-
aging cash and savings, Health and life insurance, Investing in equities and fixed
income securities, Investment in mutual funds, Contingencies, Retirement plan-
ning, Marriage, Buying luxurious and domestic products. More, we discussed on
the financial process and studied that the financial process starts with a clear
picture of your goals and then gathering as much information as possible. Third
step is to have appropriate advisors. The next step is adopting a good all-inclu-
sive financial plan and then to actually execute that plan. Final step is to monitor
and taking the corrective steps.
So this unit is going to be of great help for students in understanding more about
financial planning and making decisions in this regard.
Answers: (1-c), (2-b), (3-a), (4-b), (5-d)
193
INVESTMENT 2.5 Glossary
ANALYSIS AND
1. Zero Coupon Bond - A bond that pays no annual interest but is sold at a
FINANCIAL PLANNING
discount below par, thus providing compensation to investors in the form of
capital appreciation.
2.6 Assignment
Explain the financial planning process with all the steps.
2.7 Activities
What are the advantages of financial planning'
2.8 Case Study
Write a financial plan for yourself stating the different stages in your life and how
do you plan to meet the requirements at different stages including education, mar-
riage, buying a house, health and other contingencies.
1. Personal Financial Planning – ICFAI University.
194
Unit FINANCIAL PLANNING-II
3
: UNIT STRUCTURE :
3.1 Introduction
3.2 Derivatives
3.2.1 Future Contract
3.2.2 Forward Contacts
3.2.3 Options
3.2.4 Swaps
3.3 Difference between Forward Contract and Future Contract
3.4 Financial Planning and Preparation of Financial Plan after EFR
(External Funds Requirements) Policy is Determined
3.5 Let Us Sum Up
3.7 Glossary
3.8 Assignment
3.9 Activities
3.10 Case Study
 Basic derivatives
 That practical financial planning becomes easier if we project the financial
statements for the near future.
 How EFR can be calculated
 How funds can be raised through different sources.
 The Difference between various derivative products
3.1 Introduction
Understanding of financial planning and preparation of financial plan after EFR
(External Funds Requirements) policy is determined.
This unit will begin with introduction of derivatives. We will also learn how to
prepare financial plans to support a targeted level of sales.
3.2 Derivatives
The derivatives are most modern financial instruments in hedging risk. The indi-
viduals and firms who wish to avoid or reduce risk can deal with the others who
are willing to accept the risk for a price. A common place where such transactions
take place is called the 'derivative market'.
195
INVESTMENT
ANALYSIS AND
FINANCIAL PLANNING
Fig 3.1 Structured and Derivative Investment Products

Source – BNP Paribas website
Derivatives are those assets whose value is determined from the value of some
underlying assets. The underlying asset may be equity, commodity or currency.
They derive their value from some underlying instrument and have no intrinsic
value of thereby won. Forwards, futures options, swaps, caps and floor are some
of more commonly used derivatives.
Fig 3.2 Future Contracts

It is a standardised agreement to deliver or receive a specified amount of speci-
fied currency at specified price (exchange rate) and the date. The buyer of the
future contract receives the currency while the seller of the future contract delivers
the currency.
Only the members of the future exchange can engage in future transactions. The
members of future exchange can be classified as either commission brokers or
floor traders. Floor brokers execute order for their customers, while others work
independently. Floor brokers (also called locals) trade on their won account.
A future contract provides both a right and an obligation to buy or sell a standard
amount of a commodity, security or currency on a specified future date at price
agreed when the contract is entered into. A key element of any successful traded
futures contact must be the characteristic of standardisation; it is this element
which makes the agreement tradable. The only negotiable, changeable element
must be the price agreed when entering into the contract.
 It is a standardised specific sized contract.
 The contract has a standard maturity date. At International Money Market
(IMM) Chicago, contracts mature on the third Wednesday of March, June,
September and December.
196
 Collateral requirements: the purchaser must deposit a sum as initial depos-
FINANCIAL
its called 'margin' as collateral. In additions to initial margin, the customers
PLANNING- II
are required to deposit the maintenance margin.
 Customers pay commission to their brokers to execute the order.
 Clearing house as counter party- All future contracts are agreement be-
tween clients and the exchange clearing house rather than the two parties
involved in the transaction. Thus there is no default risk.
 Settlement on the final date of delivery. Only 5% of the contracts are settled
by physical delivery of foreign exchange between buyers and sellers offset
their original position prior to delivery date by taking an opposite position.
Future price = spot price + costs of carrying
Costs of carrying is the aggregate of storage, insurance, transport costs,
finan e costs etc.
Types:
 Commodity futures: Where the underlying is a commodity or physical
asset such as wheel, cotton, butter, eggs etc. such contracts began traded
on Chicago Board of Trade in 1860’s. India too futures on soybean, black
pepper, spices have been trading for long.
 Financial futures: Where the underlying such as foreign exchange interest
rates shares, treasurybill or stock index.
Participants in future market
 Hedgers: Hedgers wish to eliminate or reduce the price risk to which they
are already exposed. The hedging function solely focuses on the role of
transferring the risk of price changes to other holders in the futures markets.
 Speculators: Speculators are those classes of investors who willingly take
price risks to profit from price changes in the underlying.
 Arbitrageurs: They profit from price differential existing in the markets by
simultaneously operation in two different markets.
3.2.2 Forward Contacts
A forward contract involves an agreement today to buy or sell a specified amount
of foreign currency at a specified future date at a rate agreed upon today (the
forward rate). The typical forward contracts are for 1 month, 3 months or 6
months. With 3 months being most common. Forward contracts for longer peri-
ods are not as common because of the great uncertainties involved.
It is a fixed price contract made today for delivery of a certain amount of currency
at a specified future date. The specified date is the settlement date. The agreed
upon price is termed as forward rate.
No money changes hands today. The exchange takes place on future date. The
forward contract stipulates that the full amount need not be exchanged on the
settlement date. Only the difference between the forward rate and the spot rate
prevailing on settlement date will be paid.
Hedging and speculation are the main activities, which pertain to forward market.
197
INVESTMENT An agreement made today between abuyer and seller to exchange the commodity
ANALYSIS AND or instrument for cash at a predetermined future date a price agreed upon today.
FINANCIAL PLANNING A forward foreign exchange contract used to hedge a future payment in a foreign
currency entails delivery of a certain amount of one currency in exchange for a
certain amount of another currency at a certain future date.
A fixed-price contract made today for delivery of a certain amount of a currency
at a specified future date. The specified date is the settlement date. The agreed
upon price is termed the forward rate.
No money changes hands today. The exchange takes place on a future date. The
forward contract stipulates that the full amount need not be exchanged on the
settlement date. Only the difference between the forward rate and the spot rate
prevailing on the settlement date will be paid.
Forward exchange contracts may be used to hedge a future import payment or
export receipt. It can also be used for speculation. The bank may engage in a
forward contract as a service to customer the bank will then offset the forward
seeking to profit form the spread between currency bought and currency sold.
The financial- market participants seek to take advantage of an apparent ineffi-
ciency in the currency or money markets.
Forward exchange contracts are amazingly versatile. They are available in two
dozen or more currencies and for maturities ranging from one week to several
years. Many individuals and even institutions are drawn to the currency future
market, because it entails far less default risk.
Default risk in forward contracts arises because such a contract commitment for
future performance and one or the other party may be unwilling or unable to honor
that commitment.
On the settlement date, one party in effect owes the other party a net Financial
amount. The net amount and who owes whom cannot be determined in advance.
It depends on the direction and extent to which the currency has moved in the
interior.
E.g. on march 1, A agrees to buy one-pound sterling from B. 3 months forward at
a price of $ 1.75. as a convenience to both, they agree that on the settlement date
( June 3) only the net amount will be exchanged the net amount is defined to be the
difference between the forward date ($ 1.75) and the spot rate, whatever it is, in
3 months time (June 1). If the pound is above $ 1.75, B pay A the difference; if the
spot rate turns out to be below $ 1.75, A pays B the difference. Either way, the
payment will take place in dollars again, as a convenience.
3.2.3 Options
Contracts between sellers and buyers, which obligate the former to deliver and
entitle the latter without obligation to buy stated quantities of assets with stated
quality at some future dates at todays contracted prices.
The option market is not only extended to stock dealings but also to foreign cur-
rencies, commodities etc.
An option is right but not an obligation to enter into transaction.
198
Features:
FINANCIAL
 The option is exercisable only by the owner, namely the buyer of the option PLANNING- II
 The owner has ltd. liability.
 Owners of options have no right affordable to shareholders such as voting
right and dividend right.
 Options have high degree of risk to the option writers.
 Flexibility in investors needs.
 No certificates are issued by the company.
There are 2 types of options:
 Call Option
 Put Option
A put option gives the right to sell the share at a further date at the pre-determined
price. A call option gives a right to buy the share at predetermined price at future
date. Both these options are derivatives or secondary instruments. The value of
which will be different from the value of the share on which it is
based.
3.2.4 Swaps
“A swap can be defined as the exchange of one stream of future cash flow with
another stream of cash flows with different characteristics.”
“A swap is an agreement between two or more people/ parties to exchange sets
of cash flows over a period in future.”
Swaps can be divided in two types:
 Currency swaps: the currency swaps are agreements whereby currencies
are exchanged at a specified exchange rate and specified intervals. The
basic purpose of swaps is to lock in the rate.
Interest Rates Swaps: An interest Rate Swap is an agreement whereby one
party exchange one set of interest rate payments for another. Most common ar-
rangement is an exchange of fixed interest rate payment for another rate over a
time period. The interest rates calculated on notions calculated of principals
1. The __________are most modern financial instruments in hedging risk. a.
Swaps
b. Derivatives
c. Options
2. “A swap is an agreement between two or more people/ parties to
______________sets of cash flows over a period in future.”
a. exchange
b. Buy
3. An option is ____________but not an obligation to enter into transaction.
a. Wrong
b. Right
199
INVESTMENT 4. _________________, one party in effect owes the other party a net amount.
ANALYSIS AND a. Buy date
FINANCIAL PLANNING
b. On the settlement date
5. The ________________, changeable element must be the price agreed
when entering into the contract.
a. only negotiable
b. Market
3.3 Difference between Forward Contract and Future Contract
Forward contract Future contract
It can be for any amount as per the A future contract is not available for a
requirement of individual parties. particular amount, because it is
required to be for a prescribed amount
only.
It can be in non-standardized form at. It is always in a standardized format.
It is not regulated through any It is regulated by an exchange legally
statutory empowered to enforce the contract.
A forward contract is not transferable It can be traded officially on the
to the other partied. It can be cancelled exchange on which it is enforceable.
or extended by mutual consent of the Therefore a future contract can be
parties. Therefore it is not very liquid considered more liquid even though
or flexible respect in respect of the there is no flexibility in it’s amount.
amount for it.
Forward contract were
originally There is always a margin payment at
designed without involving any the time of entry and there are
marginal payment, but these days periodical variation payments, which
are payable by one party and
banks insist on some marginal deposit.
receivable by another party. These
These are not periodical variation variation payments proved an
payments and therefore there are umbrella of protected to both the
greater risks of default. parties.

1. __________ can be for any amount as per the requirement of individual
parties.
a. Future contract
b. Forward contract
2. _______________, in any case, need to be translated in future cash flows.
a. Sales forecasts
b. Buy forecasts
3. The ____________established will become financial goal and should be
taken as abenchmark for evaluating performance in subsequent years.
a. financial plan
b. Marketing Plan
200
4. ______________is regulated by an exchange legally empowered to en-
FINANCIAL
force the contract.
PLANNING- II
a. Forward contract
b. Future Contract
3.4 Financial Planning and Preparation of Financial Plan after EFR Policy
is Determined
Financial statements are useful in understanding past as well as providing the
starting point for developing financial plan for the future.
Financial plans begin with the firm’s product development and sales objectives. A
corporate entity can possibly aim at either a normal growth plan, which aims at a
percentage growth in sales. This probably does not aim at making inroads into
competitor’s share. If it is an aggressive growth plan which calls for increased
market share or entry into new areas and new products will call for heavy invest-
ment in machinery, equipment, land, building, etc.
Sales forecasts, in any case, need to be translated in future cash flows. If future
operating cash flows are insufficient to cover the planned investment in fixed as-
sets and working capital and to meet planned dividend payments, then the bal-
ance has to be made good by borrowing or by the issue of new shares.
In chapter I, we had discussed EFR (External Funds Requirement). This was an
introduction to what is now understood as financial plan. We will sum up four
steps involved:
Step 1: Project next year’s operating cash flow assuming the agreed percentage
of increase in sales.
Step 2: Project additional investment in working capital and fixed assets that will
be necessary to support the higher level of activity. At this stage, also take into
consideration the dividend payout.
Step 3: Observe the difference between the projected operating cash flows as
per step 1 and projected uses of funds as per step 2. The difference represents
the cash to be raised either by borrowing or by issuing shares.
Step 4: Once it is decided about mix of debt and equity it is necessary to prepare
a projected balance sheet that will incorporate new levels of assets, revised re-
tained earnings and new debt as well as equity.
In actual practice it is possible to set up a spreadsheet, which can project for the
next five to seven years in terms of projected income statements and projected
balance sheets.
The financial plan established will become financial goal and should be taken as
abenchmark for evaluating performance in subsequent years.
The process of financial planning will force the management to combine effects of
the firm’s investment as well as financing decisions. This is very important because
these functions, namely, investment, financing and dividend are not independent
of each other and must interact.
It should be carefully noted that the financial plan model does not necessarily lead
to optimal financial strategy. In actual practice, it has been experienced that finan-
201
INVESTMENT cial planning generally proceeds by trial and error. The primary purpose of finan-
ANALYSIS AND cial statements is to produce accounting statements but good finance managers
FINANCIAL PLANNING can make use of the financial plan to achieve maximum possible growth in
shareholder’s network.
External Funds Requirement [EFR] leading to financial planning.
The EFR Model assumes that if the sales have to go up then the investments in all
assets should proportionately go up.
This is generally true for the Current Assets but not true for Fixed Assets and
therefore the Model is defective to some extent.
The Model also assumes that if the sales go up, spontaneous liabilities will also go
up proportionately. This is also logical. A formula is available for calculating EFR
but it is advisable to understand the fundamentals behind it. We can calculate EFR
by preparing a projected B/S for the sales, from the past turnover.
Financial Forecasting Planning
Steps to Calculate EFR :
(i) Calculate conversion factor and determine increase in EFR
(ii) Calculate retained earning and add it to previous year balance.
(iii) Calculate all assets and liabilities as per conversion factor.
(iv) Remaining funds to be arranged from equity share capital.
(v) Don't apply CF to equity share capital and retained earnings.
Problems for Practice
1. The balance sheet of Pradhan Company at the end of year 2020, which is
just over, is given below: (R '000)
BALANCE SHEET
Share Capital 50 Fixed assets 130
Retained earnings 60 Inventories 90
Long term loans 80 Receivables 80
Short term borrowings 60 Cash 20
Trade Creators 50
Provisions 20
320 320
The sales for the year just ended were R 4,00,000. The expected sales for the
year 2021 are R 5,00,000. Net profit margin is 5% and the dividend pay out ratio
is 50%.
Required:
1. Determine the external funds requirement for Pradhan for the year 2021.
2. The Balance sheet of Damodar Chemicals Limited as on 31st March, 2020
is given below:
202
Rs. In Rs. In FINANCIAL
Liabilities Assets
Lakhs Lakhs
PLANNING- II
Share Capital 75 Fixed Assets 200
Retained Earnings 90 Inventories 100
Term Loans 40 Receivables 75
Short-term Bank 100 Cash 25
Borrowings Accounts
70
Payable
Provisions 25
400 400
The sales of company for the year ending 31.3.2020 amounted to R 500 lakhs
with a profit margin of 6 per cent. The dividend payout ratio was 50% and the tax
rate was 60%. The company expects its sales to rise by 30% for the year 2020-
21. The profit margin ratio, the tax and the dividend payout ratio are also ex-
pected to remain unchanged.
Required:
 Estimate the external funds requirement for the year 2020-21.
Draw up the projected balance sheet as at 31st March, 2021.
2. The balance sheet of Pragathi Limited as on 31st March, 2020 is given
below:
(R In lakhs)
Liabilities Rs. Assets Rs.
Share Capital 25 Net Fixed Assets 100
Retained Earnings 35 Inventories 50
Term Loans 60 Accounts Receivables 35
Bank Borrowings 30 Cash 15
Current Liabilities
Accounts Payable 40
Provisions 10
200 200
Net sales for the year 31st March, 2020 was R 400 lakhs and the projected sales
for the year 2020-21 is R 500 lakhs. The net profit margin on sales is 5% and
dividend payout ratio is 60%. The tax rate for the company is 50%.
a. Estimate the external funds requirement for the next year (2020-21)
b. Prepare the following statements, assuming that the external funds would
be raised equally from term loans and short-term bank borrowings.
 Projected balance sheet
 Projected income statement
203
INVESTMENT ANSWERD :
ANALYSIS AND (1) Pradhan Company :
FINANCIAL PLANNING
New Sales 5,00,000
(a) Conversion Factor = = = 1.25
Old Sales 4,00,000
(b) Fuarease in EFR = Old total assefs × CF – Old assets
= 320 × 1.25 – 320.
= 400 – 320
= 80
(c) Estimated refained eavnings :
Sales 5,00,000 × NP ratio 5% = 25,000
12,500
lers : Dividend pay out 50%
12,500
(d) EFR :
Particular OLD CF NEW Increase
Assets FA 130 1.25 162.50 32.50
Inventories 90 1.25 112.50 22.50
Receivables 80 1.25 100.00 20.20
Cash 20 1.25 25.00 5.00
320 1.25 400 80
Liqbihpes
Long term loan 1.25 100.00 20.00
Short terms borromings 50 1.25 62.50 12.50
Trode creditors 50 1.25 62.50 12.50
Pronsions 20 1.25 25.00 5.00
To be spared from 210 1.25 262.50 52.50
Retained earnings & 110 137.50 24.50
equlity capital
less : Retained earnings 60 72.50 *12.50
Equity share capital 50 - 65.00 15.00
Capital 110 131.50 27.50
(2) Damodar Chemical Limited :
(a) New Sales = Old Sales 500
+ 30% 150
650
New Sales 650

(b) Conversion Factor = = = 1.3
Old Sales 500
(c) Fuarease in EFR = Old total assefs × CF – Old assets
= 400 × 1.30 – 400
204
= 520 – 400
FINANCIAL
= 120 PLANNING- II
(d) Estimated refained eavnings :
Sales 650 × 6% = 39.00
23.40
Less : Ta × @ 60%
15.60
7.80
less : Dividend pay out ratio 50%
7.80
(e) EFR :
Particular OLD CF NEW Increase
Assets FA 200 1.3 260 260
Inventories 100 1.3 130 30
Receivables 75 1.3 97.50 22.50
Cash 25 1.3 3.50 7.50
400 1.3 520 120
Liqbihpes
Term loan 40 1.3 52 12
Short terms Bank 400 1.3 130 30
Payables 70 1.3 91 21
Provisions 25 1.3 32.50 7.50
235 1.3 305.50 70.50
165 214.50 49.50
Less : Refrained earnings 90 97.80 *7.80
Equity share capital 75 - 116.70 41.70
165 214.50 49.50
(2) Pragati Limited :
New Sales 500

(a) Conversion Factor = = = 1.25
Old Sales 400
(b) Fuarease in EFR = Old total assets × CF – Old assets
= 200 × 1.25 – 200
= 250 – 200
= 50
(c) Estimated refained eavnings :
Sales 500 × NP ratio 5% = 25
12.50
Less : Tax @ 50%
12.50
7.50
lers : Dividend pay out ratio 60%
5.00
205
INVESTMENT (e) EFR :
ANALYSIS AND Particular OLD CF NEW Increase
FINANCIAL PLANNING Assets
Net Fixed assets 100 1.25 125 25
Inventories 50 1.25 62.50 12.50
Accounts Receivables 35 1.25 43.75 8.75
Cash 15 1.25 18.75 3.75
200 1.25 250.00 50.00
Liqbihpes
Term loans 60 1.25 75 15
Bank borrowings 30 1.25 37.50 7.50
Accounts Payables 40 1.25 50.00 10
Provisions 10 1.25 12.50 2.50
140 1.25 175.00 35.00
60 75 15
Less : Refrained earnings 35 40 *5
Equity share capital 25 - 35 10
60 75 15
Projected Income Statements

Par ticular s R (In
Lakhs)
Sales 500
Le ss : Cost of gords sold + Expe nses
@ (95%) 475
Net Profit @ 5% 25
Le ss : T ax @ 50% 12.50
12.50
Le ss : Divided Pment @ 60% 7.50
5.00
Projected Balance Sheet :

Loabilities R Assets R
Equity Share Capital 35 Net fixed Assets 125
Retained earnings 40 Inventories 62.50
Accounts receivables 43.75
Term Loan 75 Cash 18.75
Bank borrowings 37.50
Accounts Payable 50
Provisions 12.50
250 250
1. _____________leading to financial planning.
a. External Funds Requirement [EFR]
b. Financial forecasting
206
2. The ________________assumes that if the sales have to go up then the
FINANCIAL
investments in all assets should proportionately go up.
PLANNING- II
a. FER Model
b. EFR Model
3. The Model also assumes that if the sales go up, _______________liabili-
ties will also go up proportionately.
a. premeditated
b. spontaneous
4. A ___________________is available for calculating EFR but it is advis-
able to understand the fundamentals behind it.
a. formula
b. Mathode
3.5 Let Us Sum Up
In this unit we studied about the derivatives in very detail.After going through this
detiled unit the readers will get sufficient insight of derivates.
Here we studied the different type of derivatives is like future contracts, Forward
contracts option and Swaps are explained in this topic these types of contract and
markets are helpful for the investors as well as regular traders in the market. The
derivatives are most modern financial instruments in hedging risk are those assets
whose value is derived from the value of some underlying assets. The underlying
asset may be equity, commodity or currency.We even studied the various types of
derivatives products such as Future contracts, Forward Contacts, Options, and
Swaps are traded in the Indian market. A detailed discussion was also made on
EFR Model under which we studied that this EFR Model assumes that if the sales
have to go up then the investments in all assets should proportionately go up. This
is generally true for the Current Assets but not right for Fixed Assets and therefore
the Model is faulty to some extent. In option product, there are two types of
options- call option and put option.The Model also assumes that if the sales go
up, spontaneous liabilities will also go up proportionately. This is also logical. A
formula is available for calculating EFR but it is advisable to understand the fun-
damentals behind it. We can calculate EFR by preparing a projected B/S for the
sales, from the past turnover.
So this unit is going to be of great help for the readers in understanding the con-
cepts relating to derivates.
Answers: (1-b), (2-a), (3-b), (4-b), (5-a)
Answers: (1-b), (2-a), (3-a), (4-b)
Answers: (1-a), (2-b), (3-b), (4-a)
207
INVESTMENT 3.7 Glossary
ANALYSIS AND
1. Accruals - Continually recurring short-term liabilities especially accrued
FINANCIAL PLANNING
wages and accrued taxes.
3.8 Assignment
Explain the concept of derivatives with its different types.
3.9 Activities
How the Future Market Transaction is beneficial to the investors/ traders' Explain
with an Example
3.10 Case Study
How the Future Market Transactions/Future contracts are beneficial for the trad-
ers' How they are contributing in the development of Indian capital market'
1. Financial Management ….Ravi Kishore.
2. Financial Management …..I. M. Pandey.
2. Financial Management …..P. C. Tulsian & Bharat Tulsian
208
Unit DIVIDEND & DIVIDEND POLICIES
4
: UNIT STRUCTURE :
4 .0 Learning Objectives
4.1 Introduction
4.2 Definition of Dividend
43 Types of dividend
4.4 Forms of dividend
4.5 Dividend and Provisions under Companies Act 2013
4.6 Procedure for declaration and payment of final dividend
4.7 Determinants of dividend policy
4.8 Dividend Policies
4.9 Let us sum up
4.11 Glossary
4.12 Assignment
4.13 Activities
4.14 Case Study
After learning this unit, you will be able to understand:-
- Meaning of Dividend.
- Types and Forms of Dividend.
- Legal Provisions for Dividend.
- Procedure for payment of final dividend.
- Factors affecting dividing policy.
- Different dividend policies.
4.1 Introduction
There are three important decisions of traditional financial management.
These decisions are finance decision, investment decision and dividend decision.
Finance decision is about creation of Funds. Which sources of funds are desir-
able for the firm are evaluated by the financial manager and most appropriate
funds are selected by the manager. It is about formation of capital structure. Im-
portant decision is investment decision. It is known as capita! budgeting. Capital
budgeting is long term investment decision. In investment decision working capital
decision is included by some authors. Both decisions - finance decision and in-
vestment decisions are covered under other units of other blocks. Third important
209
INVESTMENT decision is about dividend distribution. The basic objective of any business enter-
ANALYSIS AND prise is to maximize the wealth of business consequently investors can be ben-
FINANCIAL PLANNING efited by this wealth maximization here are two approaches about distribution of
dividend. According to one approach distribution of dividend brings increase in
value of shares while second approach favours retention of earnings. The distribu-
tion of divided always affects liquidity position of the enterprise, if adequate liquid-
ity maintained by the enterprise, then it is desirable to pay dividend. There is one
class of investors seeks regular payment of dividend and another class believe in
capital appreciation. So for financial manager and management of the company it
is crucial decision to pay dividend or not to pay dividend. The role of financial
manager and management of the company is to take balanced decision to justify
to pay and to not pay dividend.
4.2 Definition of Dividend
(i) An amount paid generally on regular basis by the comp share holders annually
out of its profit or reserves.
(ii) A dividend paid by the company to its share holders is return to shareholders
for their investment in the company.
(iii) The term 'Dividend' has been defined under Section 2(35) of the companies
Act, 2013. The term 'dividend' includes any dividend. In general term dividend
means the profit of company which is not retained in the business and is distributed
among equity shareholders in the proportion to the amount paid shares held by
them.
4.3 Types of Dividend
Dividend
For Equity Shareholders For Preference Share holders
Interim Dividend Final Dividend

(i) Interim Dividend:
This dividend is declared before the declaration of final dividend There are several
factors which are considered before declaration of interim dividend - these factors
are present profit status, profit status of future, liquidity of the company, market
trend, orders on hand etc. This is one kind of additional dividend which is paid
over and above final dividend. Interim dividend is a dividend which is declared
between two annual general meetings.
(ii) Final Dividend:
It is that dividend which is paid on yearly base. At the end of accounting period,
the accounts of company are prepared. After preparation of accounts board of
directors evaluate liquidity, profitability position of the company, expectations of
investors etc. With the consideration of important factors BoD recommends
dividend to shareholders to approve it in annual general meeting, Once it is
approved in AGM it becomes liability to the company and to be paid by the
company in stipulated period of time.
210
(iii) Preference Share Dividend:
This is separate group of shareholders. They are having preference of two things
over equity shareholders and that is dividend payment and redemption of capital.
Rate of dividend for this group of shareholders remain fixed.
4.4 Form of Dividend
Dividend is that part of profit which is distributed by the company to the
shareholders. Generally, corporate pay dividend in the form of cash. Dividend
payment has direct relation with liquidity status of the company. If sufficient liquid-
ity exists no firms will have any problem to pay dividend. In spite of having suffi-
cient liquidity, company does not pay dividend i.e. funds are retained for expan-
sion purpose. Sometime, company might have problem of liquidity. In brief when
company does not want to pay dividend in cash to the shareholders. Is there any
other form to give return to shareholders? Sometimes, firms may declare dividend
in the form scrip, bond, stock, and property dividends. The following are the
different forms of dividends.
(i) Cash Dividend:- This is most popular and desirable form of dividend pay-
ment This form of dividend is linked with good liquidity position. If company does
not maintain enough cash (liquidity) it will create hurdle for dividend payment.
During preparation of cash budget, the factor of dividend also should be consid-
ered so that with appropriate liquidity level dividend can be paid without any
hurdle.
(ii) Scrip Dividend: - The form of dividend is used when firm has weak liquidity
or shortage of cash. In this form of dividends, the equity share holders are issued
transferable promissory notes. Here dividend payment is made in the form of
promissory note. It may or may not be interest bearing.
(iii) Bond Dividend: - Bond dividend and scrip dividend are similar in all
aspect except maturity period. The duration of bond dividend is longer compared
scrip dividend. Bond dividend bears interest. Again this form is used when firm
has lower or weak liquidity position.
(iv) Property dividend: - This form of dividend is not so popular. This form of
dividend assists to maintain liquidity position of the firm because no cash dividend
is paid in this form. Different assets which are not required by the company is
given to the shareholders in the form of dividend. This form of dividend. This form
of dividend payment is not popular in India.
(v) Stock Dividend (Bonus Share):- Under this form of dividend additional
shares of common stocks to the ordinary shareholders. It is poplar in USA and
known as stock dividend to existing shareholders. Due to this dividend payment,
bonus shares are issued to the existing shareholders and consequently reserves of
the firm are converted into equity. The declaration of bonus share will increase the
paid up share capital and reduce retention of earnings. Due to issue of bonus
shares, there will not be any change in net worth of the firm.
4.5 Dividend and Provisions under Companies Act, 2013
(i) Dividend payment on paid up value:- Under Section 51 stated that compa-
nies pay dividends in the proportion the amount paid up on each share when paid
211
INVESTMENT value of all equity shares is different. While, in case of preference share, dividend
ANALYSIS AND is always paid at a fixed rate.
FINANCIAL PLANNING (ii) Final Dividend:- It is recommended by the Board of Directors in their
meeting and after approval in annual general meeting of equity shareholders be-
comes payable.
(iii) Interim Dividend:- An interim dividend is declared by the Board of Direc-
tors at any time before the completion of respective financial year.
(iv) Source of Dividend Payment:- No dividend shall be declared or paid by
the company for any financial year except out of profits of the company after
deduction of depreciation. Dividend can be paid from profits of the company of
previous financial years but by fulfilling other provisions.
(v) Transfer to Reserve:- It is mandatory to keep certain percentage of profit
as a reserve before the deduction of any dividend in any financial year.
(vi) Separate Bank Account:- Any amount of dividend whether final or interim
shall be deposited in a separate bank account within 5 days from the date of
declaration of such dividend.
(vii) Time:- Dividend has to be paid within 30 days from the date of
declaration.
(viii) Unpaid Dividend:- If dividend has not been paid or claimed within the 30
days from the date of its declaration, the company is required to transfer the total
amount of dividend which not paid or unclaimed to a special account to be opened
by the company in a scheduled bank to be called Unpaid Dividend Account. This
amount shall be transfer within 7 days from the date of the said period of 30 days.
(ix) Power of SEBI:- In case of listed companies section 24 of the Companies
Act, 2013, confers on SEBI, the power of administration of the provisions
pertaining to non - payment of dividend. In any other case, the powers remain
with Central Government.
(x) Investor Education and Protection Fund:- Any balance amount of unpaid
dividend account of a company which is remain unpaid or unclaimed for an period
of seven years from the date of such transfer shall be transferred by the company
to the investor Education and Protection Fund.
(xi) Directors Responsibility:- When declared dividend is not paid by the
company within 30 days from the date of declaration director shall, if he is know-
ingly a party to the default, be punishable with imprisonment for a term which may
extend to 2 years and shall also be liable to a fine of H 1,000 every which default
continues.
(xii) Delay in transfer of unpaid / unclaimed dividend:- If the company de-
lays the transfer of the unpaid / unclaimed dividend amount to the unpaid dividend
account, company will have interest @12% P.A. till it transfers the same.
(xiii) Mode of dividend payment:- Dividend payable in cash may be paid by
cheque or warrant through post directed to the registered address of the share-
holder who is entitled to the payment of the dividend or to his order or in any
electronic mode sent to his banker.
212
4.6 Procedure for declaration and payment of final dividend
The following steps are to be followed for declaration and payment of final
dividend.
(i) Meeting of Board of Directors:- Meeting of Board of Directors to be
arranged in accordance with Section 173 of Companies Act. In this regard notice
must be issued which states time, date and venue of the meeting and details of the
business to be undertaken. This notice to be sent to all directors for time being in
India.
(ii) For listed companies:- In case of companies which are listed on stock
exchanges, companies have to notify stock exchanges, at least two working days
in advance of the date of the meeting of its Board of Directors at which the
recommendation of Final dividend is to be considered.
(iii) Resolutions:- Necessary resolutions are to be passed pertaining to
approval of final and recommending the quantum of final dividend to be declared
at the next annual general meeting.
(iv) Annual General Meeting:- For approval of dividend recommended by the
board of directors, fixing time, date and venue for holding in the next annual
general meeting of equity shareholders of the company.
(v) Authorization to Company Secretary:- Approving notice for the annual
general meeting and authorizing the company secretary to issue the notice of the
AGM on the behalf of the Board of Directors of the company.
(vi) Closure of Register:- As for Section 91 of Companies Act, 2013 date of
closure of register of members and the share transfer register is determine by the
company the dates so fixed should not in conflict with the clearance programme in
the stock exchanges.
(vii) Reserve Creation:- It should be ensured that the mandatory percentage of
profits is transferred to company's reserve.
(viii) Listed Company & book closure: - A public notice is to be circulated by
listing company for book closure in a news paper of district in which the
registered office of the company is located, at least 7 days before the date of
commencement of book closure.
(ix) Holding of AGM :- Annual General Meeting to be arranged and pass an
ordinary resolution declaring the payment of dividend to the shareholders of the
company as per recommendation of BOD. The shareholders cannot declare the
final dividend at a rate higher than the one recommended by Board but they can
recommend for lower rate.
(x) Dividend Statement :- A statement pertaining to payment of dividend to
each shareholder is prepared by the company.
(xi) Dividend Distribution Tax: - Dividend distribution tax should be said to
the tax authorities within the prescribed time.
(xii) Separate Bank Account :- For payment of dividend separate bank
Account should be operated by the bank and total amount of dividend should be
credited within 5 days from the dividend declaration date.
213
INVESTMENT (xiii) Mode of Dividend Payment :- In case of listed company payment of
ANALYSIS AND dividend, it is mandatory to use either directly or through its registrars to an issue
FINANCIAL PLANNING and share transfer agents (RTI and STA), any Reserve Bank of India approved
electronic mode of payment such as Electronic Clearing Service (ECS) National
Electronic Fund Transfer (NEFT).
(xiv) Dispatch of Warrants: - All dividend warrants should be dispatched within
30 days of the declaration of dividend. In case shareholders, dispatch the divi-
dend warrant to the first named shareholders.
(xv) Unpaid Dividend Account:- It is mandatory for the company to open ac-
count named "unpaid dividend account within 7 days after expiry of the period of
30 days of declaration of final dividend for unpaid / unclaimed dividend.
(xvi) Investor Education and Protection Fund (IEPF) : Again it is mandatory
to transfer any balance of unpaid / unclaimed dividend amount in unpaid /
unclaimed dividend account to investor education and protection fund after the
expiry of seven years form the date of transfer to unpaid / unclaimed dividend
account.
Check your Progress -1
1) Dividend is distribution of ______.
(a) Loss (b) Profit
2) Interim Dividend is paid on ______.
(a) Equity Share Capital (b) Preference Share Capital
3) Dividend which is declared between two annual general meeting is ______.
(a) Final Dividend (b) Interim Dividend
4) Dividend rate is fixed on ______.
(a) Preference Share Capital (b) Equity Share Capital
5) Stock Dividend is known as ______.
(a) Bonus Share (b) Bond Dividend
6) Dividend is given in the form of asset is ______.
(a) Scrip Dividend (b) Property Dividend
7) Separate Bank account is to be open within ______days from the date of
declaration.
(a) 7 days (b) 5 days
8) Dividend is to be paid within ______ days after declaration of it
(a) 30 days (b) 7 days
9) Unpaid dividend account is to be transferred to investor education and pro-
tection fund in ______.
(a) 7 Years (b) 7 days
4.7 Determinants of Dividend policy
The determination of dividend policy cannot be done in isolation. It is de-
pendent decision. There are several internal and external factors which are to be
considered before finalization of dividend policy. These factors are as follows.
214
(i) Economic Condition: - When economic condition is growing the firm may
pay high dividend but when state of economy is uncertain, both political and
economical, the firm may maintain a low dividend payout policy. It is a external
factor.
(ii) Expansion Project: - Any firms when having any expansion project require
additional funds. Retained earnings are internal source of finance. If retained earnings
is used as a source of finance dividend payout ratio will reduce. It is internal
factor.
(iii)Degree of Control:- If management does not want to spread control by
issuing share, in this case firm can use retained earnings as a source of finance.
Consequently payment of dividend would decline.
(iv) Cost of Capital :- The cost of external source like equity, preference and
debenture is explicit cost while internal source retained is implicit cost. When
external sources are costlier, firm would go for internal source so dividend pay-
ment will be reduced.
(v) Earning Status :- The flexibility in earnings is one of the constraints which do
not allow predicting its future earnings. On the other stable earnings help to pre-
dict future earnings. A stable firm is therefore more likely to pay higher dividend.
So earning status is also one of the factors for payment of dividend.
(vi) Liquidity :- Without or with poor liquidity the payment of dividend is not
possible and desirable. In order to pay dividend, a company requires cash and
therefore the availability of cash resource of the important issues of dividend
payment.
(vii) Divisible Profit :- The determination of divisible profit requirement. Only
divisible profit can be distributed as dividend, Otherwise it is treated as payment
of dividend out of capital.
(viii) Legal Provision :- It is mandatory for any company to transfer specific
percentage of profit to General Reserve. This transfer also reduces the quantum
of payment of dividend.
(ix) Contractual Constraints:- If company has used debenture and / or prefer-
ence capital which leads to fixed payment of interest and Dividend and if com-
pany passes through recession period, company will have lower amount of profit
and lower dividend will be payable to equity shareholders.
(x) Additional Capital good: - A firm intends to raise further funds from the
capital market for its expansion and diversification projects to attract the funds
from the capital market; it has to maintain a liberal dividend payment.
(xi) Rate of expansion: - If one time expansion project is required to execute
funds raising needs will be different if the more rapid the rate at which the firm is
growing, the great will be its needs for financing asset expansions. The greater the
future need for funds, and company wants to use internal source, dividend pay-
ment will be reduced.
4.8 Dividend Policies
There are different types of dividend policies adopted by companies. The
application of dividend policy is based on management's philosophy, regularity in
215
INVESTMENT liquidity and profitability. Another aspect is whether company is having developed
ANALYSIS AND or developing stage and many more. The important dividend policies generally
FINANCIAL PLANNING followed by companies are as follows:
(1) No dividend in initial period dividend policy.
(2) Regular or Fixed dividend policy.
(3) Regular dividend plus extra dividend policy.
(4) Irregular dividend policy.
(5) Regular stock dividend policy for certain period.
(6) Regular plus stock dividend.
(7) Liberal dividend policy.
(1) No dividend in initial period dividend policy:
This kind of dividend policy is generally adopted by developing companies.
In spite of having sufficient lent profit, profit is not distributed in the form of divi-
dend but reinvested in the business. Reinvestment is cheapest sources of finance
so instead of having external finance companies goes for this source of finance.
This policy is not preferable for long period of time. It is same minimum rate of
dividend is expected by the shareholders.
(2) Regular or fixed dividend policy:-
It is believed that payment of dividend always enhances the credit dividend
is also desirable. This policy further can be classified into two categories (a) con-
stant dividend payout policy (b) constant dividend rate policy.
(a) Constant dividend payout policy:-
Under this method regular or constant rate of dividend is applied on earn-
ings per share. Fixed percentage of earnings per share is paid to equity sharehold-
ers as a dividend. So if earning varies, the amount of dividend also varies from
year to year. This method is quite volatile, fluctuating with changes in the economy
and firms own special circumstances. This method is generally not used by major-
ity of firm. The difference between earnings per share and dividend per share is
retained earnings. This policy can be shown as follows
216
(b) Constant Dividend Rate Policy:-
Under this policy of dividend, dividend payment is made on constant rate
even when earnings vary from year to year. This may be possible only when the
earnings trend of the business entity does not show wide fluctuations. This policy
is generally applied when dividend equalization reserve is maintained by the com-
pany. Firms are generally careful to set the dividend as a sustainable level and
raise it only when the firm can sustain the higher level. Occasionally firm may cut
dividends in reserve situation. This Policy can be shown as follows:
(3) Regular dividend plus extra dividend policy:-

Well established and reputed companies have trend to pay regular and / or
constant dividend to maintain their image in the market It is also possible that
when companies earn abnormal profit, directors pay extra dividend in addition to
regularly, yearly dividend. This payment of extra dividend is not regular is nature.
(4) Irregular dividend policy:-
This policy is desirable for those companies where their income is not regu-
lar. Under this policy neither rate nor amount of dividend is certain. It is purely
based on earnings of the company. Generally every company makes effort to pay
dividend but when income or earnings of the company are not certain in this case
company pays irregular dividend.
(5) Regular stock dividend policy for certain period:-
When company has liquidity problem or company wants to expand its own
business in this case company does not pay dividend to the shareholders but gives
stock dividend for certain period of time. Under this policy size of equity capital
keeps on increasing and consequently in future dividend per share gets reduce.
This policy is not favored by the expert field.
(6) Regular plus stock dividend: -
Under this policy company try to maintain regular dividend payment to
own shareholders. This policy is desirable for the following circumstances (i) com-
pany wants to pay regular dividend (ii) company wants to use retained earnings
(iii) company having profit does not want to distribute dividend in cash form.
In brief under this policy companies want to achieve two goals i.e. payment of
dividend and maintaining cash in the business.
(7) Liberal dividend policy: -
This is purely based on approach of the management. When management
distribute maximum amount of earnings in the form of dividend and retains insig-
217
INVESTMENT nificant amount of earnings as a retained earnings is known as liberal dividend
ANALYSIS AND policy. When company earns higher profit pays higher dividend and when earns
FINANCIAL PLANNING lower profit pays lower dividend under this policy. Liberal dividend policy is one
kind of irregular dividend policy.
Check Your Progress - 2
1) For determination of dividend policy economic policy is ______.
(a) Internal Factor (b) External Factor
2) Whether expanse object is internal or external factor for determination of
dividend policy.
(a) Internal Factor (b) External Factor
3) Which kind of liquidity status of the company is desirable to pay dividend?
(a) Good Liquidity (b) Poor Liquidity
4) Retained earnings has______cost.
(a) Implicit (b) Explicit
5) Cost of retained earnings is______ than cost of equity
(a) Less (b) More
6) Under liberal dividend policy______amount of profit is distributed as
dividend.
(a) Maximum (b) Minimum
7) Under which policy cash dividend is not paid?
(a) Regular dividend policy.
(b) Stock dividend policy for certain period.
4.9 Let us sum up
In this unit we have studied meaning of dividend and dividend policies and
related aspects thereon.
Dividend is return to shareholder for their investment. This return is paid by
the company from its profit. Dividend payment can be done in different form but
most popular and desirable form is cash dividend. Dividend is paid on equity
share capital and preference share capital. Dividend is preference share capital
while on equity share capital it is not fixed. Dividend payment has certain legal
restrictions in this regard several provision companies Act, 2013. Dividend
decision cannot be taken management in isolation. Internal and external factors
have influence on dividend payment. Therefore before making any dividend
payment due consideration is given to them. Within the legal frame work all
companies have liberty to decide their dividend policy so for understanding of it
different dividend policies are also discussed and explained.
Your Progress -1
Answer :- (1-b), (2-a), (3-b), (4-a), (5-a), (6-b), (7-a) (8-a), (9-a)
Your Progress - 2
Answer :- (1-b,) (2-a), (3-a), (5-a), (6-a),(7-b)
218
4.11 Glossary
1. Dividend: The term "Dividend" has been defined under Section 2(35) of
Companies Act, 2013. The term ''Dividend' includes any interim dividend.
2. Unpaid Dividend: It is that part of dividend which is not paid/ claimed by
shareholders within the 30 days from the date of its declaration.
3. Investor Education and Protection fund: It is that balance of unpaid di-
vided account, if it remains unpaid for a period of 7 years from the date of transfer
of dividend to unpaid account will be transferred to Investor Education and Pro-
tection Fund.
4. Annual General Meeting: As per Section 96 of the Companies Act, 2013,
every company, other than one person company (OPC) must hold a general
meeting in each year apart from other meetings as Annual general Meeting.
4.12 Assignment
Describe different dividend policies adopted by companies.
4.13 Activities
Discuss about different form of dividend.
4.14 Case Study
Analyze dividend policy of any one company through annual report of last
five years of that respective company.
1. Financial Management - Ravi M. Kishore
2. Financial Management- I.M. Pandey
219
INVESTMENT Block Summary
ANALYSIS AND
In this block we had a detailed discussion on few of the very important topics such
FINANCIAL PLANNING
as investment and financing decisions and few other very important topics.
Here in this block under unit 1 a detiled discussion was made on about Investment
and Financing Decisions, detailed analysis was made on Components of cash
flows, discussion was also made on the complex Investment Decisions. Further in
unit 2 a detiled discussion was made on Advantages of financial planning, Need
for Financial Planning, Steps in financial planning, Types of Financial planning,
Scope of Financial planning. In unit 3 Derivatives, Future Contract, Forward
Contacts, Options, Swaps, Difference between Forward Contract and future
contract, Financial Planning and Preparation of Financial Plan after EFR Policy is
Determined. In unit 4 different aspects of dividend and dividend policies are dis-
cussed to for better understanding in this regard.
After going through this unit students must have got sufficient information on these
vital topics.
220
Block Assignment

1. Components of Net Working Capital.
2. Free Cash Flows.
3. Terminal Cash Flows.
4. Scope of financial planning.
5. Definition of financial planning
6. Need for financial planning.
7. Explain in detail the concept of future contracts and the different types of
participants in this Market'
8. Give in detail the importance of financial Planning.

1. Discuss Investment decisions using capital rationing
2. What are the steps involved in Financial Planning'
3. Explain forward contracts and options
221
INVESTMENT Enrolment No.:
ANALYSIS AND
FINANCIAL PLANNING 1. How many hours did you need for studying the units?
Unit No. 1 2 3 4
Nos of Hrs
2. Please give your reactions to the following items based on your reading of
the block:

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
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222
DR.BABASAHEB AMBEDKAR
OPEN UNIVERSITY
'Jyotirmay' Parisar,
Sarkhej-Gandhinagar Highway, Chharodi, Ahmedabad-382 481.
Website : www.baou.edu.in

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BLOCK-1 BASICS OF FINANCIAL MANAGEMENT

Fig 1.1 Changing role of finance manager

1.12 Financial Management and Economics

Fig 1.2 Liquidity and Macroeconomics

Fig 1.3 The elements of Strategic financial planning

Fig 2.1 Types of Capital

3.2.1 Trade Credit

10, 000 12, 000 9, 000 10, 000 11, 000

Year Cash Inflows PV factor (10%) Present Value

Note: - There is minor difference between calculated present value, which is

12,000 12,000 12,000 12,000 12,000

3. Any Other Comments

BLOCK-2 COST OF CAPITAL, CAPITAL STRUCTURE AND

Fig 1.1 Approches

Fig 1.2 Capital Structure and Dividend Decisions

Fig 1.3 Investment Appraisal and WACC

Fig 1.4 Marginal cost of capital and WACC - Relationship

Face value 100 100

Earning per sh are (EPS). R 06 R 7.17 R 09 R 6.23

EPS before additional issue R 03 R 3.17 R 03 R 2.33

Loss per share - R 1.50 - R 3.57 - R 09 - R 02

Fig 2.1 Optimal Capital Structure

Fig 2.2 CAPM

Activity leverage Structural leverage

Contribution 3, 00, 000

New Sales 6,30,000 6,30,000

EBIT (New) 2,58,000 2,18,000

EBIT 2, 40, 000

EBIT 2, 40, 000

2, 40, 000 2, 40, 000

3.3.5 Risk is associated with Financial Leverage.

3.4.3 What is included by Total Leverage.

NEW sales 6,60,000 6,60,000

Short Answer Questions

Long Answer Questions

BLOCK-3 WORKING CAPITAL MANAGEMENT AND

Gross Working C pit l C sh Working C pit l

Perm nent Working C pit l

V ri le Working C pit l Neg tive Working C pit l

B l nce Sheet Working C pit l

Fig 1.1 Type of Capital

Fig 1.2 Factors Affecting Working Capital

Fig 1.3 Operating working Capital Cycle

How to calculate Number of Operating Cycles in a Year?

1) Gross Operating Cycle: R + W + F + D

Average amount of un drawn profit 3,00,000

Net Working 5,02,083

2 (Annual usage in units) (Order cost)

Total Inventory Cost = Ordering Cost + Carrying Cost

= (2AO / C ) i.e sqroot (2AO / C)

Source- Inventory Accounting Methods: LIFO, FIFO, Weighted Average and

Fig 3.1 Capital Budgeting Techniques

Average Annual Earnings aftertaxes & depreciation

Year Machine X (R) Machine Y (R)

Total 85,000 90,000

Following the method of return on investment ascertain which of the alterna-

Year Machine X (R) Machine Y (R)

1 15,000 7,500 7,500 5,000 2,500 2,500

2 20,000 10,000 10,000 15,000 7,500 7,500

3 25,000 12,500 12,500 20,000 10,000 10,000

4 15,000 7,500 7,500 30,000 15,000 15,000

5 10,000 5,000 5,000 20,000 10,000 10,000